Balancing risk has been extremely challenging over the past 18 months as the traditional metrics for assessing risks among different asset classes has been fundamentally affected by rising inflation, rising interest rates and weaker economic growth.
Last year both equities and bonds performed poorly at the same time, which meant bonds were unable to provide sufficient protection and diversification to multi-asset portfolios when managers needed it the most.
Many ‘alternative’ assets also struggled in this environment.
This is why Rahab Paracha, sustainable multi-asset investment specialist at Rathbones, says when thinking about portfolio construction, she allocates a certain amount of the portfolios to assets considered to be genuine diversifiers.
These are assets where the return profile requires no particular directionality from equity markets, and can provide positive returns even during periods of market distress.
Inflation is a moving, backward-looking measure. It is the kryptonite of bond investing.Kelly Prior, Columbia ThreadneedleShe adds: “We often use structured products that take advantage of specific market dislocations unrelated to equity market performance.
“For example, we own a commodity curve note, which should perform positively as the commodity curve shape returns to its normal state, following significant disruption in commodity markets last year.”
Rathbones also targets investments designed specifically to provide portfolio protection in order to reduce or offset equity risk, for example, put options.
“These are in effect insurance contracts that can provide guaranteed protection in equity market sell-offs,” Paracha adds.
“Over the past few years, we have invested in a number of put options and put spreads on the S&P 500 to protect against weaker equity markets, using them more actively when bond yields were low, recognising that they were less likely to provide protection to portfolios from that starting point.”
Shifting opportunities
Max Macmillan, investment director at abrdn, says in a high inflation environment, .It is important not only to be thinking of including real assets, commodities and cash allocations therefore, but also to be managing them dynamically versus the more traditional bonds and equities in order to successfully navigate through inflationary episodes.
Macmillan adds: "In a high inflation environment, macro conditions are volatile. There are phases of rapid nominal growth followed by monetary retrenchment, and while the overriding or emergent victors may be commodities and cash, each phase will have a dramatically different pattern of market returns.
"It is important not only to be thinking of including real assets, commodities and cash allocations therefore, but also to be managing them dynamically versus the more traditional bonds and equities in order to successfully navigate through inflationary episodes."
High inflation will lead to higher rates. But as we move through a cycle, Kelly Prior, investment manager in the multi-manager team at Columbia Threadneedle, says the advantageous opportunity available for active management will change.
Prior says: “It is important to recognise that inflation is a moving, backward-looking measure. It is the kryptonite of bond investing, eroding both the value of the capital base, but also the value of fixed future cash flows.
“Floating rate instruments however offer both capital and rising income streams to match the move in the market. Just one example of how different vehicles in the same asset class will react differently at different points in the cycle.”
Indeed, in 2022, an investment approach considered high risk was low risk due to rising interest rates and high levels of inflation that disproportionately affected fixed interest investments – an asset class traditionally deemed low risk.
This is where the acronym ‘Tina’ or ‘there is no alternative’ came into play, in the sense that if you wanted to see investment returns you needed to be invested in equities even though their performances were at times lacklustre and their future prospects were relatively anaemic.
This created an artificial buffer to equity investments, says Vanessa Eve, investment manager at Quilter Cheviot, as individuals bought into and retained these investments over other asset classes.
"However, given the dramatic falls in the prices of fixed interest investments, as well as the interest now available on cash and within money market funds, there are now options for investors to achieve returns without necessarily taking on board higher levels of risk."
To get the right kind of diversification while balancing risk in a multi-asset portfolio in volatile time, Eve says we need to go back to the first principles of investing: time in the market rather than timing the market.
This is because multi-asset portfolios that are properly diversified historically have provided positive returns alongside mitigating short-term volatility.
A blend of fixed interest, equity and alternative investments will still provide steadier performances over the long term rather than taking large bets on any one asset class.Vanessa Eve, Quilter CheviotShe adds: “This will be punctuated by periods of dislocation, such as what we saw last year where low risk assets, such as gilts and US treasuries, massively underperformed higher risk assets such as equity investments.
“However, we need to remember that 2022 was dominated by the war in Ukraine and the measures taken by central banks to tackle inflation.
“The impact of these events is now factored into the prices of various different asset classes and as such a blend of fixed interest, equity and alternative investments will still provide steadier performances over the long term rather than taking large bets on any one asset class.”
Eve points to the example of the company Nvidia, which is a dominant supplier of artificial intelligence hardware and software, and along with just half a dozen other names has accounted for almost all of the 12 per cent return for US benchmarks in 2023.
Eve says while this is a positive for those with solid positions in these company names, we need to remember that these same stocks saw significant falls in 2022 as high levels of inflation severely impacted the technology sectors.
The portfolio that can best withstand a range of stresses should be favoured.Rahab Paracha, RathbonesShe adds: “This is because rising interest rates reduce high-growth technology companies' future earnings estimates and therefore led to significant falls in share values.
“So while you could take the short-term performance of these stocks as a positive, not diversifying a portfolio in a high inflation environment can lead to poor performance over the longer term for these types of companies.”
Good portfolios are designed with various economic environments in mind so that they are less sensitive to downside shocks.
To best understand the level of diversification achieved in portfolios, Baylee Wakefield, multi-asset fund manager at Aviva Investors, says investors need to perform a range of stress tests.
These include both historical and hypothetical stress scenarios, given that some scenarios have occurred infrequently.
Paracha adds: “The portfolio that can best withstand a range of stresses and is optimal for the current regime should be favoured.
“Diversification should be achieved through strategic asset allocation but can also be elevated through tactical asset allocation, for example by identifying vulnerable parts of the investment universe and reducing portfolio exposure to it.”
Ima Jackson-Obot is deputy features editor of FTAdviser
