Survival of the fittest: adapting to complex markets

We have not seen such strong and synchronised macroeconomic growth momentum since before the global financial crisis. While we expect this to continue in the main, market stress events like the one we saw in February are likely to become more prevalent and investors will have to adapt to more challenging and complex financial markets ahead. As Charles Darwin said, ‘It is not the strongest of the species that survive, nor the most intelligent, but the ones most responsive to change.’

Focus on real investment risk

A true understanding of risk will be essential as we move into the next phase of the cycle. Quantitative easing (QE) has significantly modified the risk profile of the main traditional asset classes and we are likely to see another shift in risk expectations as QE is reversed.

We believe volatility is an ineffective proxy for real investment risk, and yet is widely used in popular risk management models.

There are hundreds of billions of dollars invested in computer-driven strategies using volatility to determine asset allocation and these models are likely to amplify market corrections. When constructing portfolios, we prefer to use a broader range of measures to assess risk, such as potential losses on capital, liquidity, skewness and tail risk. In addition, we expect correlation shocks to occur more often at this stage of the economic cycle, fuelled by tighter liquidity and rising anxiety about monetary policy. The correlation between equities and bonds will evolve as bond yields rise and become more attractive relative to stock ‘yields’.

Use dynamic asset allocation with intelligent diversification

In our view, investors’ portfolios should be tilted towards assets that would profit from a growth environment, while taking into account rising inflation risk. However, with market stress events likely to occur more often, a diversified and dynamic approach will be imperative. Intelligent diversification means not just investing in a lot of different assets, but in assets that respond differently to common factors.

Diversification into alternative risk premia with a low correlation to traditional assets, such as carry, equity long/short factors or trend-following strategies, can improve the overall riskreturn profile of an asset portfolio, especially when traditional assets are looking expensive.

It will be important to have the flexibility to lower portfolio beta as required, through opportunistic hedging in the currency and options markets when risk pricing in the market is not aligned with the true level of risk. It may also be beneficial to move from a ‘beta’ style to one more focused on ‘alpha’ generation by implementing relative value trades.

Invest in equities but manage your risk

We believe investors should remain invested in equity but actively manage their risk exposure. Equities have historically performed well in periods of higher inflation and tighter monetary policy, but with valuations in some areas looking high, investors will need to be increasingly selective about the equity risk they want to take.

In our view, a passive approach to equity allocation is a risky proposition as all risks inherent in the market, good and bad, are present in the benchmark. Strategies that track market-cap weighted indices are particularly at risk of exposure to overcrowded, overvalued positions.

These indices will be vulnerable to price collapse when investors start to exit these stocks. In contrast, an active equity strategy allows investors to potentially avoid such unrewarded risks and target intended, remunerated risk more precisely. Investing in equities is not immune to interest rate risk. With monetary tightening expected, investors will need to consider the sensitivity of their equity portfolio to sovereign bonds and protect it as far as possible through active stock selection and sector allocation.

Allocate to private equity but be selective

We expect returns from private equity to remain attractive in the years to come, supported by continued economic growth and investors looking beyond traditional markets to boost returns. However, with valuations on the high side, finding good investment opportunities and maintaining price discipline will be the biggest challenges for private equity investors this year. It will therefore be important to invest in companies that can deliver the required base case return without relying solely on leverage and multiple arbitrage. Given the level of competition, we prefer strategies that allow sourcing deals outside of large auctions, such as small and mid-market buyouts, or those with a sector focus. Some caution will be needed as private equity shows some correlation with public equity and high yield bonds, both of which are looking expensive. Here again, investing selectively will be key.

As Aldous Huxley said, ‘The charm of history and its enigmatic lesson consist in the fact that, from age to age, nothing changes and yet everything is completely different.’ 2018 will offer the perfect scenario to judge how successfully asset managers can adapt their approach to a more complex market environment.