In the last five years, we have seen an increasing appetite for risky assets. Initially, this was a consequence of the search for yield and enhanced returns in a low interest rate environment. More recently, it has translated into a deeper exploration of yield opportunities on the riskier side of risky assets (such as high-yield bonds and small-cap stocks). Now, with equity markets close to all-time highs and credit spreads at historical lows, we must ask ourselves two questions:
Is it still worth being long on risky assets?
The global scenario and the stretched valuations in many risky assets present two major implications for investments. First, expected real returns are lower on the time horizon of a strategic asset allocation, compared to recent trends for most asset classes. And, risks associated with extreme (“tail”) events are increasing. So, while we felt it was appropriate to take a decisive long exposure to risky assets until last year, we now believe that building more balanced and diversified portfolios would be a better strategic choice for the market/economic scenario unfolding.
What type of approach might best pursue investor needs and challenges?
In our view,an appropriate investment approach should pursue higher performance for client portfolios in an environment where the risk-free rate is close to zero, and expected returns for risky assets have been compressed by the market trend of the past few years. Two “active” ways to help improve expected portfolio returns include:
1. Managing the “beta” component – making the overall exposure to markets more diversified
In essence, beta diversification is a valuable option for enhancing returns and we expect it to be more important going forward because of low expected returns. Beta can be diversified by broadening the range of asset classes (e.g., with multi-asset strategies), moving into illiquid asset classes and adopting a risk-parity approach. Each comes with its own challenges that must be addressed as we build portfolios.
Simply adding asset classes is not a wise option when correlation is high, as they all tend to move in the same direction. At the same time, correlations are not static and may change over time for a variety of reasons.
Moving into illiquid alternative asset classes makes sense from a pure return-enhancement perspective, as these assets embed higher expected returns than traditional ones. However, they also detract from portfolio liquidity so using volatility as a sole measure of risk is not appropriate and may be misleading for illiquid asset classes.
The risk-parity approach aims to maximize the return for each unit of risk by rebalancing the portfolio weight of each asset class in order to target a certain level of risk for the overall portfolio.
2. Acting on “alpha” generation – enhancing the portfolio manager’s ability to generate extra returns versus the benchmark, while keeping a strong focus on risk
We believe that improving the alpha component is extremely important. This approach emphasizes the role of portfolio construction, based on an efficient combination of low-correlated alpha strategies. It completely changes the way in which a portfolio is built and visualized. It allows the possibility to achieve pure alpha returns, clearly discernible from beta returns and can improve risk management of the overall portfolio, thanks to accurate risk-budgeting for each single strategy.
At Pioneer Investments, we have spent recent years strengthening the culture of alpha generation through proprietary portfolio construction tools and risk budgeting. In our opinion, this framework will become even more crucial in the new challenging investment landscape. Our approach is not set in stone but it’s an evolving process based firmly upon our active, research-driven and risk-aware investment culture.
Read the full Global CIO Letter, Investment Process: An Evolutionary Game, for a deeper discussion about how the investment process can evolve to face the new market challenges.