When is the right time for a dynamic strategy? A review of markets now, and historical scenarios including the credit crisis, Lehman Brothers and the 2013 ‘taper tantrum.’
There are times when markets do the hard work. In the past few years, for example, abundant liquidity has driven asset prices higher, and even the most non-discriminating investor has made positive returns. It has been enough simply to be invested.
However, there are times when the market doesn’t help investors, and today may be one of those times. If valuations are stretched – as they appear to be in equity markets – investors are not sufficiently compensated for the risk of taking exposure. At this point, it is important not to be dependent on beta or market risk, but to look beyond directional long-only strategies to generate returns.
At this point it makes more sense to rely more on alpha generation or non-directional strategies. This means holding less in market-driven strategies, or duration-linked strategies, and more in strategies that look at the relative attractiveness of different asset classes. Over time, there are a number of consistent return drivers: They can be value – the relative cost of an asset; or momentum – focusing on market trends; or carry – the amount investors are paid to hold an asset; or it can be macro – what macro indicators say about certain asset classes. It may also be asset class-specific indicators. In commodities, for example, it might be whether the commodity curve is in contango or backwardation. In the fixed income, it can be the yield curve.
It is possible to invest in these five return drivers in a non-directional way. In this way, they are not correlated with conventional long-only equity and bond strategies. At times when valuations are stretched, it makes sense to raise the alpha part of the portfolio to continue to achieve the long-term objective.
To see transparent, interactive view of our asset allocation decisions (and reasons why) since the inception of the First State Diversified Growth Fund click here.
Of course, it can also work the other way. There are times when it is absolutely right to position a portfolio for rising markets. When there are lots of opportunities and attractive valuations, investors don’t have to rely as much on non-directional or alpha strategies. In late 2015/early 2016, there was a significant sell-off in energy markets all around the world and emerging market currencies experienced significant volatility. We took positions in emerging market debt at that point. It made sense to allocate to ‘beta’.
The widely-used 60/40 blend of equities and bonds first became popular in the 1980s. Our research suggests that over the past 100 years, this was the best time possible for this type of allocation because equity markets were very cheap and interest rates were very high. Investors received the benefit of having high yields on their fixed income holdings and buying into a cheap equity market. Fixed income provided good protection during equity market sell-offs, because yields collapsed at times of economic stress. While this could happen again, it would be on a much smaller scale and the protection provided by this blend is far less. To our mind, investors need to look elsewhere to lower the risk in portfolios, rather than rely on this type of static allocation.
