Since the emergence of “Modern Portfolio Theory” and the “Capital Asset Pricing Model” in the late 1960s, institutional investors have taken a quantitatively driven approach to portfolio construction, looking to create portfolio diversification and obtain better risk-adjusted returns by balancing their asset-class exposures. This journey has seen several important advancements in thinking about how to optimally achieve desired results.
Funds that want to take the total portfolio approach first need to get the total portfolio view. To do that they not only need data – and lots of it – but a rock-solid understanding of exactly how they’re going to use it.
Follow the siren’s song to beat inflation woes
Amidst more reports of the death of the traditional 60/40 portfolio, investors will need to shift towards alternatives to make up the shortfall.
It’s time for investors to move heavily into alternatives, according to Evergreen Consultants. Angela Ashton, the firm’s founder and director, says investors should explore the alternatives sector more broadly, including gold, commodities, private credit, total-return multi-sector funds and real-asset funds with holdings such as infrastructure and real estate.
“What we are seeing is a mix of strong, sustained inflation coming through and interest rates rising, with last month’s Fed rate rise the first since 2018. We have reached an inflection point in the cash and bond markets. Rates are going up,” Ashton says.
The 60/40 investment strategy of allocating 60 per cent of a portfolio to equities and the other 40 per cent to fixed income is being put to the test. With rates on the rise and bond prices falling, this style of investing just won’t cut it anymore.
Investors need to look beyond the standard asset allocation strategy of chasing share market beta through passive equity funds and relying on bonds for diversification. With the war in Ukraine adding to inflationary pressure, equity investors should move to value or quality to position their portfolios more defensively, Ashton says.
Evergreen Consultants is forecasting 7.75 per cent average annual growth for Australian equities over the long term, with annualised volatility of 13.5 per cent. This is based on a view that Australia’s long-term equity risk premium (ERP) of 4.5 per cent will remain unchanged.
“Investing in bonds will be very difficult this year as we expect a lot of volatility. It would not be surprising to see yields rise further from here and it is very hard to know where they will land. Markets are volatile and there is every chance they will overshoot,” Ashton says.
Credit also has the advantage over bonds of having yields set at floating rates, which will rise as interest rates rise, but Ashton cautions that there is a greater likelihood that “some credit funds will suffer defaults in the volatile trading conditions ahead and many funds are illiquid.”
Thus the appeal of alternatives. Real assets can generate predictable income owing to consistent and stable earnings generated from the underlying asset, providing a client with visibility into revenues and dividends. Alternatives which cover commodities such as gold are also appealing during times of war. Gold is often seen as the safe haven asset where investors park cash until tensions ease. Gold, at its current level around A$2,500 an ounce, is close to a two-year high.
