By Asbjørn Trolle Hansen
Recent years have illustrated how difficult it has become to forecast potential market returns. In addition, most investors believe 2016 could be another unsettled and turbulent year – due to factors such as dislocated global monetary policies, record stock market prices, the China slowdown and political uncertainties.
Rather than making broad macroeconomic calls, we prefer to focus on capital preservation through robust risk management. By focusing on the underlying return drivers of an asset class and their diversification characteristics, rather than simply asset classes themselves, we can invest in the exact risk premiums we want and build a macroeconomic-immune portfolio.
There are many approaches to managing drawdown risks – such as buying portfolio insurances, timing volatility or risk-balancing principles. The latter is the preferred and most consistent approach, but is threatened by the ‘bond challenge’ – today’s low-yielding environment.
This is why finding alternatives outside of traditional duration will be high on our agenda in 2016. Some areas to explore are low-risk equities and quality currencies.
While the bond challenge remains real, it is still possible to find relative value in duration risk premium, especially in the US and UK. Investors are pricing in higher growth in the US and UK, with long-term yields amongst the highest in the developed markets, as opposed to the Eurozone (Germany).
With higher coupons and carry, treasury yields even have the potential to fall and generate protection to equity or credit risks should the US witness disappointing growth. Even if the Fed hikes rates this year or early next year, US duration still offers positive expected returns in the long run.
In addition, lower potential long term growth – as opposed to that seen before 2008 – has also put a cap on how high yields can move, at around 3.5%. Therefore, keeping US duration in a balanced portfolio will generate diversification and protection against equity or credit risks, while still generating positive returns from a strategic long-term perspective.
Another defensive risk premia investors may consider for downside risk mitigation can be found in low-risk equities. This type of investment is exposed to two sources of risk premia: equity beta and low-risk anomaly/quality. The equity beta acts as an ‘aggressive’ or cyclical risk premia, and remains attractive in a low yield environment over the long term compared to credit. The low-risk anomaly still persists, despite yield-hungry investors herding into the space searching for yield over the last few years.
However, as the low-risk area of the equity market that typically exhibits higher dividend yields, investors cannot simply buy blindly into low-risk equities, as any increase in government bond yields can threaten performance. Therefore, it is imperative to control both valuation and interest rate sensitivity when investing in quality companies. Opportunities for relatively inexpensive low-risk equities still exist in the healthcare, telecommunication services and utilities sectors.
Finally, quality currencies – when undervalued – can also provide protection and diversification in a balanced portfolio. For instance, sterling today can act as a funding currency as it is fairly expensive from a Purchasing Power Parity viewpoint. Conversely the JPY appears cheap, especially against the point, and a long JPY position could potentially generate an anti-beta behaviour.
Asbjørn Trolle Hansen is head of the multi assets at Nordea Investment Management
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