Over the last 12 months, investors everywhere have been facing a fundamental shift in macroeconomic trends.
On the back of that, Australia’s sovereign wealth fund, Future Fund, is to release a position paper with the current working title “The death of traditional portfolio construction”.
The edgy and thought-provoking title highlights that – depending on type, mission and mandate – asset owners may have to rethink how they assess their portfolio construction and asset allocation in a future of sustained inflation, deglobalisation and increased geopolitical risk. These fundamental shifts call for a more resilient portfolio.
These are issues that investment professionals generally haven’t had to think about in the last 30-40 years. Thus, unfortunately, even portfolio construction playbooks from the 1970s might not apply for what is going to happen in the next 5 to 10 years, Future Fund argues.
Against this backdrop, AsianInvestor asked asset managers how and why Asian asset owners should construct resilient portfolios for the ongoing changes in the macroeconomic fundamentals, and how such portfolios will differ significantly from portfolio constructions prior to 2022.
The following contributions have been edited for clarity and brevity.
Chang Hwan Sung, director of solutions research
We believe investors need to review risk/reward periodically for their strategic asset allocation in this environment and may also consider more dynamic allocation using leading economic indicators and risk appetite indicators. This is because a responsive and adaptive approach to changing macro conditions may be required, seeking to harvest return opportunities or mitigate unwanted risks.
For strategic asset allocation, our view is that cyclical assets tied with an accelerating economy like broadly syndicated loans, small cap equities, value factor-oriented strategies, and emerging markets seem to be front-loading returns, an indication that growth prospects may be positive going forward. We anticipate Sharpe ratios of portfolios will increase and the value of diversification will return as correlations between assets normalize.
Tactically in shorter term, we overweight equities relative to fixed income, tilting in favor of emerging markets, cyclical sectors, and factors such as value and small and midcaps. We are overweight credit risk via lower quality sectors, and neutral on duration. We underweight US dollar compared to other currencies.
In private assets, our long-term return expectations for shorter duration private credit such as first lien debt has improved. Private assets remain a strategic decision based on liquidity needs and investor goals, be it improved returns, enhanced income, or diversification.
Clive Maguchu, senior strategist
State Street Global Advisors
We expect market uncertainty and volatility to persist for some time in 2023. However, we anticipate more clarity later next year as rates peak with inflation falling in much of the developed world. Despite this easing in rates and inflation pressures, we anticipate a bumpy road ahead so 2023 will not be a straight path.
With this prevailing macroeconomic uncertainty, the challenge for Asian investors is to construct resilient portfolios that differ to the strategies that have worked prior to 2022. This means themes such as downside protection, maintaining defensive stances in equity allocations and real asset exposure, and retaining some cash to be more tactical will be key attributes for portfolios going forward.
From our discussions with Asian investors, we know that they have been overweight growth in their equity allocations. We believe that a more balanced factor exposure with a near-term tilt towards value and quality stocks is warranted. While the current environment is challenging for China and emerging market allocations, further weakness in the US dollar and China reopening could signal a turn for these markets.
Asian investors also tend to favor yield in their portfolios. The much higher yields now available in fixed income relative to recent history means greater allocations to fixed income should be considered, particularly when the inflation peak becomes more apparent in 2023. Within fixed income we favor government bonds and high- quality credit. We also see opportunities in private credit.
Saira Malik, chief investment officer
Our 2023 portfolio construction themes center on seeking resilience through investments that can power through a cyclical downturn and provide the ballast that has eluded investors in 2022. And, at the same time, account for the damage in public markets and the consequential imbalance in private markets.
We suggest emphasizing three central themes. First, we adopt a less cyclical stance. The increased likelihood of a recession, and the price deflation that would accompany it, poses a risk to already challenged corporate revenue growth. In equities, this makes us more cautious toward cyclical areas, while favoring quality, dividend growth and public infrastructure.
Second, we strengthen core bond holdings. After an atypical year in which bonds failed to provide meaningful diversification benefits or ballast to portfolios, we think conditions now warrant a modest increase in duration through higher-quality investment grade credit and municipal bonds.
Third, we carefully assess public vs. private allocations. While most public markets were broadly and deeply negative in 2022, private markets were relatively insulated from the turmoil. As a result, some investors may feel they have a potential portfolio imbalance between the two. Ultimately, the right balance between publics and privates will vary depending on investor needs and portfolio objectives. But we see differentiation across and within asset classes. Among private assets, we are highly constructive on private credit, given its defensive nature and strong fundamentals. And we also like farmland as an inflation hedge. We are seeing some growing near-term risks in areas of private real estate, while finding solid opportunities in public REITs.
Raf Choudhury, investment director of multi-asset solutions
2022 was a stark reminder that correlations are not static. Equity markets sold off aggressively this year and look further under threat when a US led global recession hits next year. Bonds which usually provide the ballast to a multi-asset portfolio in equity downturns went walkabout this year. Their defensive characteristics were nowhere to be seen as correlations converged.
Revisiting the 60/40 portfolio strategy is something that has been happening over the last few years and a trend that is only accelerating. As well as using tactical and dynamic asset allocation to navigate markets, the evolution of the 60/40 portfolio is also seeing the inclusion of a broader set of asset classes.
Bond yields might be looking more attractive now and they may still have a place to play but investors shouldn’t rely on them as their sole defensive lever in their portfolios. A more capital efficient approach by targeting longer dated bonds can allow investors to target the same overall portfolio duration with a smaller allocation. That can help to make room in a portfolio for a broader set of diversifiers or even more growth assets that might be more risk premia focused.
It’s not just going to be equity and bonds anymore. Alternatives, including tail risk hedges as well as public and private assets are increasingly being incorporated as they can provide les correlated and more diversified risk and return streams.
Sylvia Sheng, global multi-asset strategist
J.P. Morgan Asset Management
The painful slump in stock and bond markets this year has removed many of the previous valuation headwinds. Lower valuations and higher yields mean that asset markets today offer the best long-term returns in a decade.
According to our long-term capital market assumption, the forecast annual return for a US dollar 60/40 stock-bond portfolio over the next 10–15 years leaps from 4.30% last year to 7.20% given the significant repricing of markets. It demonstrates that the 60/40 can once again form the bedrock for portfolios, while alternatives can offer alpha, inflation protection and diversification. It may be too early to call a bottom in the market, but over the longer term we see this year’s turmoil creating the most attractive investment opportunities we’ve seen in a decade.
Although the investment landscape has undoubtedly changed given the disruptions brought by the pandemic, supply chain disarray and geopolitical tensions, we believe globalization will evolve but not unravel. Winners and losers will emerge across regions and industries as a fragmented global economy will reach a new trade equilibrium in the long term, one that allows for some restored efficiencies and inflation falling back to central bank targets.
Bruce Phelps, head of institutional advisory and solutions
Macroeconomic conditions - inflation and volatility - have changed and may remain elevated. Yet, the portfolio construction playbook remains unchanged - investors should construct efficiently diversified portfolios. Although stocks and bonds are more correlated, they are not perfectly so, making a balanced portfolio still relevant with perhaps a broader set of public and private assets. Treasury linkers, now with positive real yields, have been re-born as a risk-free asset. Private assets have a large role given stronger expected returns and lower volatility (private credit and buyout funds) and potential inflation protection (infrastructure and real estate).
To construct resilient portfolios, however, there is one important change from the past. Given larger allocations to illiquid private assets, institutional investors must now construct portfolios with a keen eye to liquidity risk, not just traditional volatility risk. Being a forced seller of assets to raise cash - often at punishingly wide bid-ask spreads - incurs large portfolio losses that could take years to recoup.
Asset owners must embrace new portfolio construction techniques incorporating forecasts of portfolio cash flows and their own cash flow needs. These techniques will guide investors on how to both diversify their private assets and construct the liquid portion of the portfolio - perhaps more liquid bonds and cash to offset the loss of liquidity from higher allocations to private assets.
Rob Almeida, portfolio manager and global investment strategist
MFS Investment Management
While inflation should decelerate but remain elevated relative to the pre-pandemic period, the slowdown should prove a tailwind for select bonds, particularly high-quality sovereigns, municipalities, and investment-grade issues. And relative to equities, bonds haven’t been this cheap in over a decade.
Decelerating inflation is good for fixed income but will likely halt this earnings cycle and bring a long overdue profit margin reset. But not for all. Companies with uncompetitive products or services facing elevated capital costs and mandatory capital investments will be most at risk. Softer, but still relatively higher inflation compared with the post-GFC period will likely preclude financial bailouts and a return to unnaturally low interest rate regimes. These assets will become stranded.
Conversely, while investors may find that even well-run companies have some, albeit small, level of margin reset, the opportunity to grow market share and take greater ownerships of profit pools will lead to even better operating performance over the long-term. The coming inflation slowdown and margin recession will create a new and positive earnings cycle for enterprises with a demonstrable value proposition and an ability to out-earn their natural cost of capital. And I am wildly excited about that.
David Poh, head of investment and ESG strategies in South Asia
In 2023, we expect geopolitics tensions to remain high as global growth slows to 2.2% from 3.4% in 2022, while inflation is expected to stay high. Whilst it appears inflation may have been brought under control, the re-opening of China may unleash demand and inflation may rear its ugly head again. The possibility of global growth deteriorating faster than expected remains high.
Hence, given such a backdrop, it pays to remain prudent and a balanced approach to portfolio construction, tilted in favor of high-quality fixed income, should perform relatively well in the year ahead. Fixed income yields had widened to near historical high, and the risk reward justifies allocating more weights into this asset, and credit selection remains key for superior returns.
We expect volatility to remain high, at least in the first half of 2023, given the lack of clarity of global growth and inflationary outlook. Thus, we are advocating a cautious stance towards equities, with preference for US equities to Chinese and European equities. Allocation into commodities and private assets should also enhance performance through a diversified portfolio.
John Vail, chief global strategist
Nikko Asset Management
The fact that short-term rates are so high now, and even higher than long-term rates in many countries, including the US, means that a resilient portfolio could benefit from including a relatively high weighting for such. Indeed, the era of low short-term rates will likely continue to disappear, outside of Japan, for several years ahead, barring some major global upheaval; thus, an intermediate-term allocation may be aided by a shift from the standard 60% equity/40% bond construct to an even split between equity, bonds and short-term fixed income.
Equity performance is likely to be quite choppy in the years ahead, which occasionally could distress any investor with most assets in such, while G-3 bonds in most countries have rallied enough in recent weeks and have just as much downside risk as upside risk in the years ahead. Bonds and equities in more currently somewhat distressed, but still reasonably resilient countries may have greater potential, however. Alternative assets vary so much in style that it is difficult to give a weighting for such, but in the environment ahead, some could provide good returns that could warrant a significant portion of a portfolio.
Steve Cain, diversified alternatives portfolio manager
Janus Henderson Investors
2022 was a year that some important pillars of portfolio construction, which have been relied upon for over a decade, materially changed. Hitherto diversifying investments increased their correlation dramatically this year in a downward trending market, amid rising inflation and higher interest rates.
However, with interest rates so low, bonds could not perform that diversification benefit when rising interest rates led investors to question the equity discount rate in an increasingly long-duration equity market. As such, we saw both bonds and equities sell-off.
We have also seen liquidity assumptions tested, as clearly demonstrated by UK pension funds’ portfolios and the UK bond market after the disastrous mini budget under Prime Minister Truss. This highlighted the drawback of the high investment in illiquid assets, which were partially justified by the diversification benefits of the rest of a portfolio. All these cracks in assumed models point to the need for improved portfolio construction and increased investments in liquid, diversifying strategies.
2022 served to remind us that correlations between assets, that have been somewhat stable for decades, can switch signs and create dramatic return outcomes The traditional 60/40 asset allocation may now be more attractive than it has been for many years, but less stable correlation expectations demand a change to the set and leave philosophy that had become embedded in asset allocators minds over the last decade.
Hartwig Kos, head of multi-asset allocation
It is too early to write multi-asset off as a concept, but one might find that it will have to change. The past few years were dominated by a narrative of how to find replacements for the bond allocations in a multi-asset portfolio.
Going forward, investors might well ask themselves how to replace the equity part within multi-asset portfolios. Equity valuations look increasingly dull paired with the fact that asset volatilities are bound to increase in the future. This begs the question whether one should look at a higher proportion of alternative investment in one’s portfolio. The key to success hereby is to identify the investment characteristics that one might want to have in investment portfolios.
One such example could be convexity. The idea hereby is to identify strategies that provide strong positive returns in times of severe stress while not losing too much when markets are calm. This can be achieved either through derivative strategies or though specific discretionary macro strategies or a mix of both.
As soon as one looks at option structures however, the concept of “knowing one’s strategy” becomes crucial to not be negatively surprised. Guiding principle is that these strategies must be simple; they should not be optimized and have too many parameters embedded in them. Finally, if the strategies apply leverage, we need to make sure that the leverage effect cannot move against us in a meaningful way.
Paul Kalogirou, head of client portfolio management, Asia and global multi-asset solutions, client portfolio manager
Manulife Investment Management
Asset managers are no longer operating in an environment of loose monetary conditions, rising growth and low inflation but rather a more fragmented foundation complicated by deglobalisation, resource nationalism and strained geopolitics which is creating a more challenging environment for investors. Fed policy has reversed as tighter financial conditions have de-rated equity multiples whilst fixed income returns have been eroded by inflation, rates and default risk concerns in the face of a recessionary environment.
Non-traditional and alternative assets and approaches are therefore being implemented into portfolios to benefit from the current macro regime. We also believe in customising income investing, the search for yield to add portfolio resilience into portfolio construction will remain a key theme to capture rising rates and volatility and to have flexibility around duration positioning, hedging abilities as well as using other derivative implementation strategies such as option writing to enhance yield generation for income objective constructed portfolios.
We believe in a multi-asset approach, adaptable to adjust to changing market and macro regimes with the flexibility to construct portfolios with traditional equity and fixed income asset classes, alongside non-traditional alternatives such as preferred securities, REITs, metals/mining, energy, real assets, infrastructure, agriculture, timberland, leveraging both public and private domains in order to meet investment outcomes that are relevant in the new macro environment we expect to see over the coming years.
We also believe in stringent asset manager research when populating portfolios with active and passive managers to root out specific asset manager factor biases and exposures that may or may not be relevant in the portfolio for the given macro environment. A robust due diligence approach towards asset managers is key to asset manager scoring and their deployment in global portfolios.
A look at the past decade of returns indicates that no single asset market can always outperform, the top performing asset class can be different at various points in time (chart below). However, unpredictability can afford opportunities, but investors should be thoughtful of when and where to allocate in their investment approach. For example, an allocation to the energy sector over the last five years would average to less than 2% total return; however, the same exposure to energy has returned over 20% in the first nine months of this year. Hence, diversification requires a deeper understanding of both the individual asset class and cross-asset behaviours over time.