An unprecedented investment environment means asset allocators need to be smarter about the way they manage risk, writes LGIM's Justin Onuekwusi...
How does one invest defensively in the current market environment? Several years ago, and for decades beforehand, the solution would have been very simple: build a portfolio with heavy exposure to fixed income, particularly the so-called risk-free return available on developed market government bonds.
But times have changed as central banks have tried to stimulate their economies by taking unprecedented steps to encourage governments, companies and individuals alike to borrow at very low interest rates. This policy action has provided a strong tailwind for fixed income investments in recent years, the prices of which have been driven to abnormally high levels. This means asset allocators will need to be smarter about the way they manage risk in portfolios.
In the real world, risk does not obey the rules. Portfolio constructors must avoid the trap of thinking that markets follow a normal bell curve distribution, where most data points are clustered around the middle of the range. There are significant ‘fat tails’ to the distribution of risk that need to be considered.
Defensive investing in uncharted territory
Any assessment of the future path of bond returns must be rescaled to take into account the base from which yields start at today. Given that yields are currently so low, it is entirely unrealistic to expect a similar period of falling yields.
Forward-looking risk management tools need to be developed and utilised, including scenario analysis that blends historical scenarios with possible future scenarios.
For the end-investor, the nature of a defensive asset allocation depends entirely on the context of the situation. In our own portfolios, for example, we have increased exposure to global inflation-linked bonds because we think it is important to look globally for diversification, as well as provide some measure of protection to guard against an uptick in inflation.
Given the shifting risk profile of fixed-income investments, multi-asset funds will have to be more aware of country-specific risks in an environment where the rating agencies are downgrading the credit ratings of what were once seen as ‘safe’ bonds.
We expect to be more active with asset allocation within fixed income over the medium term, as markets adapt to a world where the US Federal Reserve, in particular, starts to scale back quantitative easing.
Risk profiling has become central to the development of the multi-asset space and I believe a risk-targeted approach makes sense as a core proposition for advisers.
There has been plenty of confusion about risk-rated and risk-targeted funds but they are different things. The process of applying a risk rating relies largely on analysis of the history of markets and looking at how various asset classes performed at different times. We know making decisions based on past performance is a bad idea.
I am not saying that professional fund managers have a crystal ball, although analysis of the current economic situation can lead to informed views about the future. Where historic analysis can really enhance the process, however, is in the general relationships between asset classes, rather than specific correlations between them.
History often rhymes but rarely repeats, and the relationship between asset classes will change in different economic climates. That is why it is important to not only look at what did happen but also what might have happened.
A robust strategic asset allocation process will do this by sampling ‘slices’ of data from different periods of market history, re-ordering these again and again to create thousands of variations. Each slice preserves the relationships between asset classes at the time, allowing for more detailed analysis.
The investment world has changed a lot over the past few years, both because of the economic and political upheaval caused by the credit crisis but also because the investment industry has reacted to the changing needs of investors.
The trend towards a more risk-targeted approach in multi-asset investing is likely to increase in future, as investors and advisers gain greater confidence and familiarity with the products and their capacity to meet their objectives.
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