Clients present a number of challenges to advisers and managers, ranging from issues over volatility to correlating asset classes. How can advisers and fund managers overcome these challenges?
Here are some classic problems and potential solutions to them.
1. With both equity and bond portfolios struggling, what are the alternatives?
In the first six months of 2018, UK equities were flat, the majority of emerging market equity markets were down and most fixed income portfolios were slightly negative.
While overall these are not huge losses it is the first time a combined equity and bond portfolio is struggling.
Traditionally, when equities are up then bonds are down, and vice versa. However, this inverse correlation has been broken. Between 2009 and 2018 we witnessed a generally positive environment where equities and bonds were both up, mainly as a result of government intervention.
This correlation has flipped, with both equities and fixed income both slightly down year to date. Most investors have not experienced this situation before. In this environment, putting risk first and being diversified are more important than ever.
To offset equity and bond markets falling in tandem, investors are diversifying their portfolio to include a wider range of asset classes.
This environment is more conducive to actively managed strategies, with liquid alternatives and unconstrained fixed income assets resonating with investors.
However, individuals should not forget the time horizon of their investments and the need to manage liquidity levels. For example, some investors are building illiquidity mismatches into their portfolios.
This was a pattern adopted by some investors in 2006-07 and did not fare well when markets fell in 2008.
2. How can I adapt to the changing fixed income environment?
The biggest theme we have seen in our client portfolios over the past three years is the reduction in the percentage allocated to fixed income.
This has been driven by the end of the 30-year fixed income bull market, although 2018 is the first year when fixed income losses have occurred.
In adapting to the changing fixed income environment, investors have turned to more unconstrained and flexible fixed income mandates, have shortened duration risk and increased their allocation to floating rate products. Investors have also replaced bond exposure with liquid alternatives and multi-asset funds.
3. Will I take on more risk in my portfolio if volatility increases?
Some investor portfolios continue to meaningfully understate risk. This is being driven by a perceived lack of attractive investment opportunities, which in turn can lead investors to take on more portfolio risk. Currently, there are limited returns to be found in bonds and most equities are fairly priced.
An absence of corporate defaults is sending some investors down the credit spectrum to find yield, but many may not understand the level of risk they are taking on as credit default rates have typically been low in a period of reduced volatility.
If volatility returns, investors will get an unwelcome surprise. Investors are taking on much greater levels of risk in portfolios to secure a similar return target, and they may not even realise it.