Generating returns and managing volatility in a changing world

Sponsor’s position paper by Tony Finding, M&G

Pension funds across Europe are facing challenges due to regulatory changes and two decades of market shocks.

Multi-asset portfolios are being increasingly seen as a solution. Diversification across an expanded opportunity set may offer the best chance of both safeguarding capital while seeking to generate attractive returns. Diversified growth funds (‘DGFs’) is one label for a new perspective on multiasset portfolios, with greater flexibility to achieve growth-style returns with lower volatility.To achieve effective diversification, these funds require an approach that goes beyond the ‘set-it-andforget- it’ methods of traditional balanced funds. Just as the best assets to hold will vary over time, so will the best ways of managing volatility.A dynamic approach to changing regimesIt is important to understand the changeable nature of correlation patterns and return opportunities in order to develop a good diversified growth strategy. This involves prepared willingness to be dynamic and active in asset allocation, rather than simply holding a wide range of assets and hoping that past correlation patterns will persist. For example, many investors are used to mainstream government bonds acting as an insurance policy for equities in recent years, but this hasn’t always been the case.The M&G Multi Asset team has been running multi-asset portfolios since the late 1990s and over that period has developed the belief that the prevailing economic regime – which is determined by such structural forces as inflation, interest rates and growth – as well as valuations are key determinants of both returns and drive the nature of volatility and correlations.In the case of government bonds for example, the team believes that they are far more likely to offer portfolio protection in ‘risk off’ periods when yields are higher and inflation is contained, than when the starting level of yield is depressed. Alternatively, there can often be surprising diversification within so-called risky assets when one can identify sections of the market with a significant value buffer in place. However, keeping an eye on these ever evolving dynamics requires active management and experience across multiple investment environments.Assessing opportunities and risk The M&G Multi Asset team believes that the best chance to navigate uncertainty is to build, and actively manage, a well-diversified portfolio of global assets for which the current price over-compensates the holder for the level of fundamental risk. This forms the bedrock of the team’s ‘Episode’ philosophy, which they have used to manage multi-asset portfolios for over 15 years.The essence of the ‘Episode’ investment process is in-depth valuation analysis combined with elements of behavioural finance to exploit attractive investment opportunities anywhere around the world. It is centred on the observation that, while value is the key determinant of long-term returns, prices often move for non-fundamental reasons. Such phases or ‘episodes’ can create opportunities to generate returns over long or short term periods. Any investment requires consideration of three key variables – the price at which you buy, the price at which you sell, and the nature of the journey in between – but it is only ever possible to be certain about the first. The team therefore focuses its resources on researching and analysing the ‘fair value’ of a wide range of global assets relative to their current prices.