In the wake of the market turmoil, institutional investors are left to make sense of what has fundamentally changed and to adjust their portfolios to capture opportunities while protecting their assets from another possible meltdown. In light of recent events, it’s clear that institutional investors have come to appreciate the importance of true diversification, liquidity and downside protection. But positioning their portfolios for an uncertain economic and financial recovery will take creative solutions, along with exposure to growth and risk assets to meet investment objectives down the road.
During the global downturn, rising correlations among asset classes, underperformance and market illiquidity all contributed to drawdowns in institutional portfolios, reversing many years of improvement in a short period of time. While institutional investors have varied needs and objectives, the results have been largely similar. Against this backdrop, it’s no surprise that many investors are seeking solutions that simultaneously address drawdown risk and asset growth. We believe this is an ideal time for all institutional investors to assess their portfolio strategies and plan for the future.
Give Us a V!
The key question is, Can an equity rally continue to lift investors out of the hole left by the market crash of 2008/09? Or will they need to rethink their basic assumptions, including the main tenets of asset allocation and the historical risk/return relationship?
Investors are wondering how they are going to meet their objectives going forward, and much depends on what the economic recovery will look like. Predictably, market pundits, academics and economists are laying out a multitude of scenarios for an economic recovery, and all have major implications for institutional investors.
Economic recovery talk generally takes the form of a letter such as “V,” “W,” “U” or perhaps even “L.” (Though an L shape can’t be classified as a “recovery,” as it implies a non-recovery.) But what does that mean, and what are the implications for investors? Investors will need to choose one or some combination of these scenarios and adjust their portfolios accordingly.
Investors have many factors to consider in positioning their portfolios, including the all-important risk management and growth aspects. They should evaluate their portfolios according to three steps: review the asset allocation policy, manage the portfolio’s risk exposure and develop an asset growth strategy.
Rethinking the 60/40 Approach
Investors should review their asset allocation policy to ensure appropriate diversification, risk budgeting and the frequency of policy adjustments. The days of the traditional 60/40 stocks/bonds mix may be over, as this approach appears to be highly correlated with equity market risk. As stocks exhibit more volatility on an historical basis, there is a good case to be made for revisiting the traditional approach to develop a solution that provides lower volatility, true diversification and risk mitigation.
Asset allocation policies should be flexible enough to allow investors to capture opportunities when they arise. When it comes to adding asset classes to a plan, investors should consider uncorrelated sources of return in addition to asset classes that provide protection under a multitude of scenarios. This could mean everything from absolute return strategies to commodities to derivatives. Fixed income, for example, presented significant opportunities for growth this year as high-yield and investment-grade corporate credit posted phenomenal returns through the third quarter. Investors who were brave enough to venture into corporate credit in early 2009 have been amply rewarded. Additionally, as views change on inflation/deflation, investors should be nimble enough to make adjustments in a timely manner.
Redefining Risk Management
Investors would also be wise to manage risk exposure to hedge against key factors such as currency risk, interest rate risk, inflation, liquidity and equity market risk—many of which were likely secondary considerations before the events of the last two years. Now there are many more risks to consider, which will require creative solutions for all investors.
Investors also have to consider how an economic recovery will drive risk and return characteristics across the investment landscape. The timing of governments’ withdrawal from various sectors of the economy and financial markets will likely impact interest rates, the inflation outlook and various currencies. The tremendous intervention by the U.S. government has caused it to become the nation’s largest lender, insurer, automaker and guarantor. While the U.S. and Canadian governments have pledged to “unwind” themselves from the private sector, it is unknown how this will occur and what the impact will be for investors.
The unwinding process in Canada, the U.S. and abroad has generated much discussion about the potential for inflation or deflation. And the time to consider inflation hedging is not when inflation has become problematic: investors should always hedge against inflation and inflation potential. Asset classes that traditionally serve as an inflation-hedging strategy include commodities, real assets and government-issued inflation-protected debt, such as real return bonds.