Five investment questions answered

This article is part of
Diversity that delivers no nasty surprises

Certain questions crop up with some regularity when it comes to multi-asset investing; here I attempt to address a few of them.

1. How can investors deal with low expected returns in traditional asset classes?

Investors may wish to consider an investment approach which can achieve effective diversification while pursuing alpha creation. To gain further positive, risk adjusted returns against the benchmark advisers can use ‘satellite’ strategies, in addition to the conventional top-down directional strategies (what many call ‘macro strategy’, based on the view of the world).

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We believe there is a broad opportunity available looking at relative value strategies – that is, among different sectors, currencies, countries, or yield curves. For example, in current market conditions, central banks’ asynchrony provides many opportunities for relative value strategies.

Moreover, through additional ‘selection’ strategies, investment managers can potentially further enhance the portfolio by adding returns from the selection of single securities in the equity and credit markets, either through direct investments or selection of ‘best of breed’ third-party managers.

This process can help generate sufficient returns even in an environment of extremely low interest rates. At the same time, it is important to focus on risk management, which – especially after the financial crisis – has become a priority for investors and one of the top needs for clients. Risk management is designed to help mitigate the consequence of increased volatility that investors experienced, for example, in the month of May, during the bond market sell-off.

2. What are the implications of a multi-polar world for investment decisions?

A multi-polar world brings instability and uncertainty, which means that, there are several risks that could trigger alternatives to a base case scenario at any given time. It is crucial to have a ‘macro hedging’ strategy in order to manage portfolio volatility and downside risks arising from these alternative scenarios. This strategy can consist of a number of hedges that the manager hopes will perform positively during market stress, and counterbalance negative effects from adverse market conditions. I believe it is important that there is a broad sharing among investment specialists of the main risks affecting portfolio returns. In this sense, a risk map with short-, medium- and long-term outlooks associated with the base case can be a powerful tool to support investment decisions. Based on this, it is possible to develop alternatives to the base case. By performing a comprehensive analysis of the different scenarios, both the probability and the potential profitability impact of each extreme event can be assessed. Volatility and stress test correlation analyses should be run before deciding which risks are worthwhile hedging against.

3. How can stability conditions in a multi-asset approach be assessed?

An initial assessment of financial stability conditions can be conducted when the macroeconomic framework for the base case scenario is defined. Both global and regional economic conditions should be considered. Four key factors – demographics, politics, social and economic health – can be analysed and each can be evaluated through specific qualitative and quantitative indicators.