By Patrick Fenal
Sometimes, I wonder if asset allocators realise how lucky they used to be. We used to have the luxury of combining bonds with equities to form a diversified portfolio, but quantitative easing has destroyed the very properties of fixed income that made the asset class an essential part of a balanced allocation. Factor investing may be the best solution we have.
The search for diversification
Domestic sovereign bonds still form the basis of most European investors’ asset allocation. These bonds used to provide an attractive yield as well as strong diversification benefits. But what do we actually mean by diversification? For me, it means they could be relied upon to protect an investor’s assets when it really mattered. What’s more, the coupons they provided alone would often account for most of an investor’s expected returns, and sometimes their projected liabilities. This now seems like something of a dream.
What other asset classes can provide diversification? Real estate is an obvious example, but its poor liquidity is a major drawback. Institutional investors tend to have mixed feelings about commodities, as they are attracted by their (sometimes) low correlations but put off by their volatility. Hedge funds, for their part, seemed to be the miracle cure around 2000 but – and this only applies to the better ones – they are at best interesting satellite solutions.
The problem is quite simple. Investors want to be able to replicate the past behaviour of sovereign bonds, but in today’s world that’s impossible. They are no longer safe and, without a yield, they may have lost their ability to provide diversification. Worse still, we can envisage scenarios in which rates move higher while the stock markets fall. And what will be the long-term rationale for investing in bonds that do not provide a yield? Counter-party diversification cannot justify the high probability of investors losing their money after the effects of inflation.
Asset class boundaries have blurred
The natural thing for investors to do in recent years has been to seek diversification by allocating to asset classes, such as other areas of fixed income, that resemble sovereign bonds. But a major problem with these strategies is that they behave more like equities than sovereign bonds. This is far from reassuring! It’s probably the exact opposite of true diversification.
Alternatives, meanwhile, are a fantastic concept, but quantitative easing has killed off volatility and, in the process, most long-volatility strategies. This has led investors to favour equity-related strategies instead. What’s more, the hedge fund space has become extremely blurred between areas such as liquid and illiquid absolute return, total return, unconstrained fixed income and more.
At the same time, equities have become more complex. The ultra-low-yield environment and the search for return has resulted in some parts of the equity universe becoming a substitute for fixed income, and more likely to react negatively if rates increase sharply.
The need for a new asset allocation system
We still use an old asset allocation system that has worked well overall for several decades. But now, the ingredients of a traditional balanced portfolio have changed massively in nature.
So what do asset allocators have at their disposal today? Not much, other than factors. Factors are quite similar to asset classes in that they both require a risk premium, but factors are more straightforward to deal with – they are a pure mathematical measure. Factors don’t care if the data relate to convertible bonds or equities; they will spot the moving force behind the series. The bad news is that client constraints, regulation and investment processes will have to evolve for us to be able to use them in place of the old system combining bonds and stocks. I hope this will happen quickly enough that we don’t have to wait until major issues arise in traditional asset allocation, forcing us to recognise that there is a problem.
Factors are neither a panacea nor cheap. Their relationships are not stable over time and their definitions are still to be standardised. But they do provide us with a useful level of diversification and represent a fascinating new dimension in how to measure and respond to risks.
Patrick Fenal is deputy chairman of Unigestion
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