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The case for multi-asset absolute return strategies
Laura Blows speaks to Suzanne Hutchins, global portfolio manager and member of the real returns team at Newton, about why pension funds should look to multi-asset absolute return investment strategies
What are the main reasons for implementing a multi-asset absolute return strategy? What role could it play in a pension fund portfolio?
With this type of strategy, the aim is to achieve a return over the long term that beats inflation and cash, but also to do it with much lower volatility. The smoother profile of returns is another aspect that pension funds are looking for. Our view about the world is that it is going to continue to be a low return economic environment with a huge amount of uncertainty and volatility and a lot of that has been about the significant amount of debt in both the developed and developing world, and the response to that, which are causing markets to be extremely volatile.
What about the risks that implementing a multi-asset absolute return strategy might have for investors? For instance are clients regretting implementing that strategy now that equities have re-rated?
I certainly think that clients, particularly looking back over the last year, wish that they had been fully invested in equities given the very decent returns, but obviously that doesnt take into account the amount of risk you are taking in order to generate that sort of return. We have taken a very cautious view about the outlook, largely based on some of the long term structural themes and trends in the market place, including the level of indebtedness, demographics, globalisation and high energy costs. But above all what is most important is the valuation that you pay for risk assets. And right now we think it is a very elevated level.
Can managers time changes to add value to these multi-asset absolute return strategies?
I think there is a fantastic opportunity in multi-asset. As you are not constrained, you are not tied to a benchmark and there is not any rigid allocation. Because of the unconstrained nature, you can use volatility and flexibility in the markets to be able to buy those types of securities that you think will generate a decent return with lower volatility over the long term but at the right price. So if you get a volatile backdrop, setbacks in the market, that actually provides a fantastic buying opportunity for certain risk assets.
What areas are you looking at in terms of the buying opportunities you mentioned?
We do tend to go for very liquid type securities that we understand, daily priced, and certainly there is a long-only element, a strategic element to the portfolio. We use derivatives, both indirect and direct protection, to really insure the portfolio from some of these left tail events that we are concerned about. The opportunity set right now is more limited as most risk assets are actually at very extended levels. That being said, there are some global companies with the equity basis that look very good value, for example within healthcare.
There are whole swathes of the global equity market that we are not invested in. High yield we have got that as part of the return-seeking core but the weight is much smaller now and the duration of those assets are very short, less than two years. Where yield spreads have narrowed the absolute return level, you are not really being compensated for the risks you are taking. So we are finding it very difficult to replace the book of high yield debt security that we have got in the portfolio.
We have got some exposure to infrastructure. Again, it is not exactly cheap so we are very selective, and in the offsetting layer where we are trying to dampen volatility and preserve capital, there are certain elements within government bonds, particularly tactically, that we are using to really try and smooth out the longer term returns for the portfolio.
There is no significant geographical bias, although we have got more exposure to pan-Europe at the moment, and obviously the US market has been the place to be over the past few years, so valuations are quite extended there. Emerging markets obviously have suffered quite considerably, as well as the currencies and at some point that will be a good time to be buying on an individual stock-by-stock basis, it could be equities, it could be debt, but right now where we are currently positioned, we are pretty cautious about the backdrop given the level of valuations.
What are you more concerned about, inflation risk or deflation risk, and why do you think that is?
We need to define what actually inflation is, because inflation under the normal measures such as CPI or RPI, that in terms of an inflation measure is not really showing any signs of pick up in terms of real wage growth. That being said, we are seeing inflation in a huge number of financial assets, whether its the equity markets, or high yield, whether its bitcoins or the art market or housing market as well. So certainly inflation is coming through because of policy and the money generated thats been finding a home in financial assets.
As investors we are being forced to take on more risk as interest rates are very low. So right now in terms of our outlook for inflation and deflation, I think the risk of deflation is greater in this moment of time, and in fact you are seeing it in the US treasury bond yields, which did peak at 4 per cent and have come back down to about 3.4 per cent now.
There are deflationary forces through the scale of and level of indebtedness in the developed and developing worlds, the lack of growth, particularly with the emerging markets slowing down, the fact that demography implies an ageing population and lower growth prospects as well means that despite all this policy response we havent really seen much of a pick-up in activity, and so the Feds balance sheet is up four-fold since the financial crisis.
I think policymakers are probably more worried about deflation at the moment but we would be worrying about inflation further down the road and if it does filter out into other types of assets or even wage inflation, that would actually be both positive for the market in the short term because you have got better consumer spending power, but also it could be quite concerning as profit margins for businesses are at cyclical highs. If you get some wage growth and the possibility of interest rates going up at the same time that could really have a squeeze on profits, and profits that are highly valued in the market does tend to suggest that there is more downside risk.
What is your view about what will happen within multi-asset absolute return strategies over the next five years?
Despite the significant rally that we have seen in risk assets we still believe that we are in this lower return environment. It is going to be a channel of volatility and there is going to be upside swings as well as down losses. As our view was back in 2004 when the strategy was first launched, we do believe that a multi-asset approach is very relevant for diversification, for de-risking, and for capital protection as well as trying to generate some kind of decent return. At this juncture I think the returns outlook is quite compromised by the valuation of all types of assets, but that doesnt mean to say that further down the line, it could be tomorrow, next week, next month, next year, that some event or opportunity will rise whereby you would be able to get into some of these attractive risk assets at a much more compelling valuation.
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