Certain trends tend to persist in a fragile investment environment, but will often reverse more brutally, says Fiona Frick in her essay for finews.first.
This article is published on finews.first, a forum for authors specialized in economic and financial topics.
According to our proprietary macroeconomic indicators, global growth is now uneven between regions and heading towards below potential growth or even potentially recession. The current environment requires a significantly different, much more selective approach to risk allocation than the one that has prevailed over the last 10 years. Actively managing risk, and having the flexibility to adapt, will be essential.
In a period where economic growth is decelerating, growth assets such as equities, private equity and credit should be treated with care as their risk-reward profile is deteriorating. During previous slowdowns, government bonds have acted as a powerful diversifier, but their hedging capabilities are now more limited as yields are already at very low levels (at least in Europe).
«Increased volatility and slower profit growth are likely to dampen investor appetite»
Investors need to broaden the tools they use to diversify their portfolios to include a different exposure to equity and larger allocation to alternative asset classes.
As the road to market turning points can be long and punctuated by more frequent market stress events, it will be important to remain cautiously invested in growth assets, such as equities. Increased volatility and slower profit growth are likely to dampen investor appetite for pure market beta exposure in the years ahead and to create more differentiation in returns. An active approach will be crucial to navigate the transition. Passive strategies are too prone to excesses as they make no provision for risk allocation and are more likely to be invested in overvalued, overcrowded positions that are vulnerable to sharp corrections.
In this environment, we favor investing in diversified portfolios of quality stocks with reasonable valuations that will be better positioned as the cycle moves from expansion to recession. We also recommend dynamically implementing hedges using futures and options to reduce equity exposure when the probability of market stress increases.
«Traditional asset classes are unlikely to deliver as they have in the past»
For us, this disciplined risk budgeting approach is the best way to capture the equity return premia while ensuring downside resilience, increasing the positive asymmetry of returns.
However, after a decade of strong, relatively uninterrupted growth, traditional asset classes are unlikely to deliver as they have in the past and investors will need to find alternative, uncorrelated sources of return. For investors seeking cost-efficient and transparent portfolio diversification, liquid alternative risk premia strategies (ARP) offer a compelling solution, having delivered positive long-term returns with a very low correlation to equities and bonds.
At the heart of risk premia investing is the idea that investors are compensated for accepting risks rather than buying assets: a risk premium is the reward for taking on specific investment risk. The advantage of ARP strategies is that they remove most market directionality by taking long/short positions to gain a purer exposure to the desired risk premia, thereby enhancing diversification benefits.
«The diversification benefits still held true in 2018»
Over the short term, risk premia can be volatile and ARP is no exception. Performance of ARP strategies in 2018 was disappointing, hampered by a rare combination of factors, including an unfavorable macroeconomic backdrop, inflation fears, heightened market volatility, high dispersion between U.S. stocks and a lack of long-term trends.
However, ARP strategies have recovered well from similar, short-term setbacks in the past. In addition, the diversification benefits still held true in 2018, with the SG Multi Alternative Risk Premia index delivering a 0.1 beta to MSCI AC World USD index and a 0.2 beta to the Bloomberg Global Aggregate USD-hedged index.
«Private equity is one of the few asset classes forecast to deliver high single digit returns in the next cycle»
A selective allocation to private equity also offers strong potential to enhance overall portfolio performance. Historically, private equity has performed well in late-cycle environments and has been an effective hedge against rising (or unexpected spikes in) inflation. While private company valuations may fall during an economic slowdown, the declines are usually less pronounced than in public markets. In addition, private equity is one of the few asset classes forecast to deliver high single-digit returns in the next cycle.
That said, some caution is needed. Volatility in equity markets could weigh on private equity, as correlation analysis shows that private equity does tend to move somewhat in line with public equity, although it is less subject to market sentiment. Private equity, especially buyouts, also show some correlation to the high yield market as it needs leverage and capital-efficient structures to generate required returns.
The breadth of the private equity market today allows investors to carefully manage their exposure to favor more defensive sectors or those benefiting from long-term secular trends, such as the aging population or decarbonization of our economy.
«We favour strategies that allow sourcing deals outside of large auctions»
It will also be important to invest in companies that are resilient in their own right thanks to strong market position, management, and financials and can, therefore, deliver the required base case return through revenue growth and operational improvements. With competition high, we favor strategies that allow sourcing deals outside of large auctions, such as small and mid-market buyouts, which are by nature less competitive. In addition, the small and mid-market is less correlated to GDP growth and currently enjoys lower leverage and valuations.
Looking further ahead, we believe that changing market dynamics will require investors to take a longer-term view when allocating to risk and to be capable of being contrarian for longer. Financial markets are complex: they are highly interconnected, non-linear and adaptive. Market behavior is driven by investor behavior, but investor behavior itself is shaped by market behavior.
This recursive relationship, known as reflexivity, can play a role in creating and sustaining positive feedback loops. Boom and bust cycles are a natural consequence of a system in which the interactions between the participants are more significant than the actions of any participant in isolation and, much like in the natural world, they are the enduring forces that allow markets to move back into equilibrium.
«Investors will need to accept higher tracking error and longer periods of relative underperformance»
However, this self-regulating mechanism could be put at risk by the exponential growth in rules-based investment strategies, notably passive, smart beta, risk parity, and target volatility strategies. Too much homogeneity in market participant actions can create self-fulfilling phenomena, leading to a more fragile investment environment where trends tend to persist longer, but often reverse more brutally.
In this scenario, we believe investors will need to accept higher tracking error and longer periods of relative underperformance in order to build outperformance over the long term. Investors should not forget that the real investment risk they face is losing capital, not tracking error and that they need to take active decisions in order to avoid permanent loss of capital.
While many investors claim they invest for the long term, it is very rare that short-term performance – and short-term benchmark comparisons – does not come into consideration. Adopting a truly long-term approach to investment is one of the few genuine opportunities investors can hope to exploit. However, it may require standing against the crowd and having the courage to look far enough ahead.
Fiona Frick has been the Group CEO of Unigestion since 2011. She started her career at Unigestion in 1990 as a fundamental analyst covering traditional asset classes and subsequently as an investment manager for bond funds. In 1995, she led the creation of the company’s equity activity and developed an investment process based on the Minimum Variance anomaly. She holds a Master in Business Administration from the Institut Supérieur de Gestion in Paris and a degree in Literature and Philosophy from the University of Dijon. She serves on the Board of Sustainable Finance Geneva.
Previous contributions: Rudi Bogni, Peter Kurer, Oliver Berger, Rolf Banz, Dieter Ruloff, Werner Vogt, Walter Wittmann, Alfred Mettler, Peter Hody, Robert Holzach, Craig Murray, David Zollinger, Arthur Bolliger, Beat Kappeler, Chris Rowe, Stefan Gerlach, Marc Lussy, Nuno Fernandes, Richard Egger, Maurice Pedergnana, Marco Bargel, Steve Hanke, Urs Schoettli, Ursula Finsterwald, Stefan Kreuzkamp, Oliver Bussmann, Michael Benz, Peter Hody, Albert Steck, Martin Dahinden, Thomas Fedier, Alfred Mettler, Brigitte Strebel, Peter Hody, Mirjam Staub-Bisang, Nicolas Roth, Thorsten Polleit, Kim Iskyan, Stephen Dover, Denise Kenyon-Rouvinez, Christian Dreyer, Kinan Khadam-Al-Jame, Robert Hemmi, Anton Affentranger, Yves Mirabaud, Katharina Bart, Frédéric Papp, Hans-Martin Kraus, Gerard Guerdat, Mario Bassi, Stephen Thariyan, Dan Steinbock, Rino Borini, Bert Flossbach, Michael Hasenstab, Guido Schilling, Werner E. Rutsch, Dorte Bech Vizard, Adriano B. Lucatelli, Katharina Bart, Maya Bhandari, Jean Tirole, Hans Jakob Roth, Marco Martinelli, Thomas Sutter, Tom King, Werner Peyer, Thomas Kupfer, Peter Kurer, Arturo Bris, Frederic Papp, James Syme, Dennis Larsen, Bernd Kramer, Ralph Ebert, Marionna Wegenstein, Armin Jans, Nicolas Roth, Hans Ulrich Jost, Patrick Hunger, Fabrizio Quirighetti, Claire Shaw, Peter Fanconi, Alex Wolf, Dan Steinbock, Patrick Scheurle, Sandro Occhilupo, Will Ballard, Michael Bornhaeusser, Nicholas Yeo, Claude-Alain Margelisch, Jean-François Hirschel, Jens Pongratz, Samuel Gerber, Philipp Weckherlin, Anne Richards, Antoni Trenchev, Benoit Barbereau, Pascal R. Bersier, Shaul Lifshitz, Klaus Breiner, Ana Botín, Martin Gilbert, Jesper Koll, Ingo Rauser, Carlo Capaul, Claude Baumann, Markus Winkler, Konrad Hummler, Thomas Steinemann, Christina Boeck, Guillaume Compeyron, Miro Zivkovic, Alexander F. Wagner, Eric Heymann, Christoph Sax, Felix Brem, Jochen Moebert, Jacques-Aurélien Marcireau, Peter Hody, Ursula Finsterwald, Claudia Kraaz, Michel Longhini, Stefan Blum, Zsolt Kohalmi, Karin M. Klossek, Nicolas Ramelet, Søren Bjønness, Lamara von Albertini, Andreas Britt, Gilles Prince, Fabrizio Pagani, Darren Willams, Salman Ahmed, Stephane Monier, and Peter van der Welle, Swetha Ramachandran, Teodoro Cocca, Beat Wittmann, Ken Orchard, Michael Welti, Christian Gast, Didier Saint-Georges, Jeffrey Bohn, Juergen Braunstein, Jeff Voegeli, and Gérard Piasko.
