Five investment questions answered

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).

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.

For example, let us look at the US. In terms of demographics, special attention is paid to the labour force participation rate, which is now stabilising after the concerning slide of the past decade. In the social category, the focus is on inequality and how improving labor market conditions are benefiting lower- and middle-income households that had suffered from liquidity constraints. With regard to US politics, a strong partisan separation that limits the scope for reforms can still be seen. Finally, the picture in terms of economic health is positive: stronger internal demand can make the US economy resistant to external shocks, and the low oil price may have a net positive effect on growth.

Financial stability at the asset class level with each asset class mapped according to its economic backdrop, valuations, technical and risk sentiment indicators, should be considered. The assessment of government bonds, for example, may be negative for valuations and risk sentiment, but technical reasons (flow dynamics) may likely keep rates low in 2015 despite an improvement in economic conditions. This framework may enable an investment manager to constantly monitor stability conditions globally, and contribute to important asset allocation decisions.

4. Emerging markets could be a source of instability in the next few years. How can investors participate in this area?

The outlook for emerging markets is challenging. The rapid increase in leverage, the deteriorating economic growth and the proximity of the Fed tightening cycle are the biggest concerns. However, there are opportunities driven by divergence in the ability of different nations to face the current headwinds. The economic and stability conditions of each country are analysed to assess the quality of growth, the effectiveness of monetary and fiscal policies and the commitment to reform. This can help an investment manager enter emerging markets with strong convictions and to further enhance his pursuit of alpha.

Indian and Chinese equities remain favourable choices from a medium-term perspective, as I believe both countries are well positioned to succeed in the transition of their growth model through structural reforms, bringing improvement in the business environment and in resource allocation. For this reason, despite the challenges and risks ahead, these two countries stand out among the emerging markets. For China, transition also means abandoning growth built on credit and investment in favour of a more balanced path that focuses on expansion of the service sector and consumption.

5. What other risks are there?

Geopolitical uncertainties are the most obvious risks at present, and they are exacerbated by the deteriorating situation in Greece. Concerns about a potential Greek debt default and exit from the eurozone may have substantial implications for financial assets.

The situation in Syria and the Middle East remains critical, and the unresolved Russia/Ukraine conflict is also a dangerous source of geopolitical risk. Such issues could have a significant impact on financial markets, especially as the European Central Bank’s policies and the flood of liquidity have altered natural market price equilibria. In such an uncertain environment, I believe it is important to have efficient hedging strategies and solid risk management discipline.

Matteo Germano is global head of multi-asset investments for Pioneer Investments