A core feature of the past decade has been the prevalence of unexpected events driving most, if not all, assets down. These events were also mostly "unknown unknowns" which disrupted even the most comprehensive scenarios we as investors can plan for.
Our investment philosophy always brings us back to simple principles and is rooted in humble convictions: what if we are broadly unable to forecast what’s next?
So, the real challenge, in our view, is not to cherry-pick datapoints that support a preferred scenario, but to make sure we have the tools in place to cope with any scenario.
Higher-for-longer interest rates in the next decade is a risk.
While market participants continue to focus on the short-term debate, we are considering the possibility of a longer-term regime change that may be already well underway.
Stimulus packages from the pandemic, savings built up during the same period and funding packages associated with the transition away from fossil fuels and other climate harms mean that elevated real rates could be here to stay.
Today, deeper deficits, incurred by stimulus, are still supporting prices and may exert a long-term inflationary effect.
Friction and structural change in supply chains following the pandemic – as deglobalisation and protectionism feature more prominently in industrial policy – are also driving up input costs for businesses, further underpinning more structural price increases.
But with economies slowing and demographic trends underway, consumers are progressively drawing more on accrued savings.
Beyond the consumer, the environmental transition requires immense investment by governments and businesses of approximately US$5.5trn (£4.4trn) annually to 2030.
This stands to further increase deficits and drain savings, especially as strong demand will increase the cost of materials and skills needed to green the economy.
As consumers spend today and investments are committed to the economy of tomorrow, the structural support for higher real rates gets stronger.
What does that mean for traditional multi-asset portfolios?
Changing macroeconomic and financial conditions
We may wonder if 2022 was just a bump in the road or rather a structural turning point.
After decades of low economic inflation (if not disinflation), 2022 reversed to an inflation shock.
With this reversal episode, multi-asset investors face an inevitable question after a forgettable year for equities and fixed income: is it time to abandon the 60/40 portfolio?
We are not necessarily calling the end of the 60/40 as an obvious scenario, but we strongly believe the model carries weaknesses and investors should seek improvements.
The 60/40 portfolio is built using long-term data and assumptions.
Last year has showed that risk profiling (or control) based on long-term correlations between asset classes can put investors in uncomfortable situations when these relationships break down.
Covariance structures – the patterns describing how bond and equity returns behave jointly – can be volatile enough to challenge the most well-conceived diversification strategy.
Change is constant and risk is restless: we should beware of using long-term data as a guide for the future.
For an investor questioning whether to dismiss the 60/40, we believe these insights call for prudence.
Last year was not the first time that the strategy has underperformed severely, and its prospects in the coming years appear linked to the path of real rates.
Compared to late 2021, part of the normalisation happened (fast) and the outlook is at least less unfavourable, in our view.
The real question, we believe, is how a multi-asset portfolio can be better engineered for a smoother journey across a variety of landscapes. Not a revolution we believe, but rather a continuous evolution. But what enhancements shall we consider?
Risk-based investing as a relevant investment discipline
Considering a very liquid multi-asset approach, we believe that risk-based investing, focused on balancing portfolio risk contributions rather than capital allocations, makes a lot of sense to remain agile and adaptable.
Of course, a robust risk-based approach must consider a wide variety of asset classes and rebalancing techniques.
A richer and more robust risk-based philosophy allows to consider fundamental anchors, as opposed to a simple mathematical formula applied equally and mechanically.
A robust risk-based approach also suggests that risk can take different meanings (not only volatility), can be measured in various ways and offer lots of flexibility.
Risk-based investors aim to identify a variety of factors that impact asset classes returns and their behaviour over time.
They read markets through the lens of risks, that constantly change over time and warrant a continuous monitoring and rebalancing discipline to modulate portfolio allocation as market conditions change.
It calls for flexibility and focuses on adapting rather than forecasting.
Expanding to medium and long-term investments
Using our own experience managing Lombard Odier’s pension fund for Swiss employees, we expect such a risk-based strategy to represent up to a third of a portfolio.
By managing a share of the portfolio with a very liquid and risk-controlled process, it unlocks the opportunity to lengthen the investment horizon of other investments.
In today’s landscape, we see various opportunities to exploit a longer investment horizon.
Over the medium-term (three to seven years), given the rise in yields and today’s better alignment between yields and balance sheet return requirements, we can commit more assets to a buy and hold credit portfolio with a wider range of ratings (especially across the BBB-BB universe), implemented actively with a focus on quality issuers.
Over longer horizons (above seven years), investments can be allocated towards less liquid assets and opportunities: real estate, private equity and debt, infrastructure.
Finally, we believe that in a world of high uncertainty and increased shocks happening over shorter time frames, investors should allocate structurally to a set of alternative strategies that provide convexity; in other words those strategies that could deliver a high return and benefit from market shocks and rise in volatilities, potentially at a cost of delivering low returns in supportive market conditions.
A clear structure to adapt and drive long-term returns
Altogether, multi-asset investors will always need more rather than less diversification and should favour adaptability.
The 60/40 framework is certainly not a one-size-fits-all solution but is still a good starting point, to be adapted to each investor’s priorities, but also to a changing financial world.
Aurele Storno, CIO for multi-asset at Lombard Odier Investment Management
