We have entered an investment environment comparable to a construction zone full of potential pot holes where lights are flashing: “Proceed with Caution”. While volatility and potential risks are heightened, overall return expectations are relatively low.
A predicament arises for investors as global monetary policy has been designed to penalize savings and induce risk-taking. Yields and returns from low-risk assets have declined to historically low levels, causing investors to stretch for yield by going down the credit curve and investing in less liquid or riskier assets. Unchecked risks have been largely rewarded in buoyant fixed income and equity markets with excess liquidity also dampening volatility.
The premiums for assuming risk have now compressed to levels that warrant investors adapting their portfolios to better manage downside exposure going forward. It is fortunate that the market “panic attacks” over the past few years have been short-lived, providing us an opportunity to learn the lessons of the direct correlation between risk and expected return without having to pay the price of a permanent loss of capital.
The strong return received from traditional asset classes relative to the muted volatility over the past seven years has been extraordinary. We should recognize this as a unique period in history and be careful not to project these outcomes forward indefinitely.
There is a disconnect between interest rates being at all-time lows in an artificial effort to stimulate stalling economies and stocks in many countries near record highs implicitly projecting robust growth. Investors do not need to look beyond the fact that over US$11 trillion of investments are currently held in sovereign bonds with negative interest rates – the irrational behavior of paying to lend money – to realize that risk is being mispriced. This flight to safety has inflated valuations in many assets that have historically been defensive and made them risky.
We believe this beckons caution and have been working closely with our clients to migrate their portfolios into pockets of the markets where returns remain fair relative to the risk in order to deliver more stable returns and help to mitigate the potential erosion of purchasing power.
From our experience, the perspective of investors in Asia has been adjusting to market conditions in a healthy way and expectations are more reasonable. There is a willingness to accept lower returns in exchange for predictability of investment outcomes rather than assume undue risk for which they may not be compensated.
There has been a change in both the mix of underlying assets and the nature of the investments in client portfolios. With the level of market uncertainty, we are seeing investors shift towards lower risk, yield substitutes and becoming more receptive to alternative investment strategies. There is a recognition that the traditional asset allocation strategy of 60 percent equities and 40 percent bonds may not work going forward.
To help increase portfolio efficiency with less correlated investment strategies, investors have shifted allocations towards alternative investments, such as hedge funds and private equity. From a risk-return perspective, we believe “alternatives are a good alternative”. While the inclination of many investors is to try to select the “best” hedge fund or the investment strategy that is likely to outperform, the reality is that no one can predict these outcomes in the short term.
Our recommended approach is to craft a diversified portfolio of high quality hedge funds across complementary investment strategies including equity long/short, event-driven, global macro, fixed income arbitrage and managed futures. This has generally been additive to returns and help stabilize investor portfolios.
Investment opportunities always exist for the patient investor. Areas that we see as more attractive in the current environment include Asia corporate bonds and senior secured bank loans. Excess liquidity in developed markets coupled with a home bias from investors has resulted in exceptionally low yields and risk premiums as we are all painfully aware.
Rather than go down the credit curve or assume longer maturities in the US or Europe, investors can gain a yield pick-up in Asian corporate bonds while retaining credit quality with shorter duration.
Senior secured bank loans are also an area that is not well understood by investors and provide attractive yields that are also floating rate. Being senior and secured in the capital structure of non-investment grade companies and having the floating rate feature of loans has historically translated into lower volatility than other fixed income options.
While it may not feel like it’s been an easy ride, we have benefited from an unusual and lengthy period of robust returns for both equities and bonds with relatively low volatility. It is worth heeding the road signs and realistically assessing the potential for current conditions to offer the opposite bargain of “return-free risk” in many typical safe-haven assets like sovereign bonds.
Still, by slowing down and keeping your hands on the wheel, there are select opportunities to realize fair returns in less trafficked areas of fixed income and alternative investments while de-risking your portfolio to navigate the road ahead.
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