In understanding our portfolio strategy, it’s useful to start with the macro economic outlook and framework.
We are in an environment that is supportive to risk assets. We expect growth levels to marginally improve during the coming year, with enhanced certainty about the outlook following the broad-based improvement in the US and pick up in momentum elsewhere.
This is likely to be accompanied by subdued inflationary pressures and an ongoing supportive policy stance from central bankers across the developed world. We believe it is an environment where equity multiples can grow beyond historic averages.
While this is broadly supportive for risk, it is primarily equity risk, given the challenges that exist elsewhere, and therefore our positions are focused on being overweight in equities generally, but particularly developed markets. These positions are material, but they are far from our maximum potential positions – not least because the longer term economic outlook involves a number of challenges as the developed world goes through the deleveraging process with limited tools to manage downturns in the cycle.
This in itself will make markets more sensitive to weakness in growth and particularly volatile when any recession or deflation fears emerge. It warrants a more controlled approach from a risk management perspective. Nevertheless, our positive view of the market cycle outweighs the structural headwinds. The reverse is the case for emerging market assets where we are underweight across all portfolios.
Outside equities, we are very underweight and highly active. In spite of low inflation and the strength of the corporate sector, the risks within fixed interest are not equal and the downside risks are not sufficiently compensated by yield. We hold a small overweight position in high yield, but are cautious in all other areas. Stretched valuations lead us to investigate taking an active approach where outperformance, or alpha, becomes a more important driver than market returns, or beta – a key part of our portfolio construction process.
Our asset class strategy work is far more complex than the simple premise that “we want alpha”. The key from our perspective is whether it is available and worth the cost. This differs across asset classes and we take a fully active or a blended approach depending upon a number of factors.
In fixed interest, we are confident that we have sufficient quality in the universe to justify taking more active risk and increasingly combine traditional exposure with more flexible or total return strategies that actively manage both duration and capital structure risk.
The proceeds of our fixed interest underweight have been allocated to absolute return strategies. We are focused towards long/short equity and market neutral funds.
We do not use property across any of the portfolios and are strategically sceptical about whether this is appropriate due to the mismatch between the asset class and our portfolio requirements. Asset allocation preferences are targeted to developed market equities and absolute return. We are prioritising highly active approaches in fixed income, absolute return and selective equity markets. Most importantly, we ensure all exposure provides sufficient alpha to compensate for both risk and cost.
Toby Vaughan is a multi-manager at Santander Asset Management
