For more than a decade, equities have been in vogue. The relentless rise of stock markets since the 2008 global financial crisis has ensured that “buying the dip” has been a successful investment strategy, which, by a process of Darwinian selection, has fuelled the rise of many a senior investor. But what has underpinned this one-way bet?
Tina — there is no alternative (to equities, that is)
As equity dividend yields dwarfed diminishing fixed-income coupons, suppressed by lower and lower interest rates, the multiples applied to equities rose steeply.
It seemed irrelevant that many companies’ supercharged valuations were not underpinned by dividends at all, but were simply growth companies in a new paradigm — a shift in consumer demand for cleaner, more ethical and technologically pioneering investments.
However, with the advent of rampant and persistent inflation, “there is no alternative” (Tina) to equities has “turned”.
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Global stock markets were down by more than 21 per cent in the first half of 2022, and equities can arguably no longer be “simply the best” investment choice for investors.
Concurrently — and at odds with the predominant trend this century — fixed-income assets have also cratered in 2022, driven by fears of rising interest rates.
Until now, bonds and equities have delivered positive but uncorrelated returns.
This low correlation has enabled a diversified portfolio, commonly referred to as 60:40 (60 per cent equities and 40 per cent fixed income) to deliver a stable growth profile to investors.
But that paradigm seems to have come to an end. This year's second-quarter collapse in 60:40 returns surpassed even that experienced during the worst quarter of the global financial crisis.
All this carnage to investors’ portfolios seems be happening like a slow-motion car crash.
Volatility, as measured by the CBOE Volatility Index (also known as the VIX “fear” index) is rising, but at a gradual pace relative to the sell-off in asset markets.
One argument for this is that the market overheated because of post-Covid-19 government stimulus. This was driven by furloughed employees looking for entertainment and using stimulus cheques to trade in stocks on no-fee apps, based on the advice of Reddit forums.
Whatever your choice of market elixir, it might be argued that a correction was to be expected and what we are seeing is the froth that is being blown off the top of the market. After all, based on the past decade of returns, investors are still in the money.
The fall in markets has been implausibly smooth so far but if the VIX is to be believed, further volatility is expected.
Given that statement, the asset allocation community faces some dilemmas.
Has the correction thus far sufficiently priced in the expected risks? Now that equities have lost a fifth of their value since the start of the year, are they more or less attractive? Is credit pricing in a sufficient level of defaults, making this an attractive point to add to positions?
Or should investors seek diversification from these asset classes in anticipation of further negative returns to come? In short, should you buy, should you sell or should you hide?
We do need another hero, not a private dancer
The quest for real diversification has begun and has been a driving force behind investors’ growing interest in alternatives in recent times.
Investors who previously relied heavily on the traditional equity-bond 60:40 portfolio model have found themselves increasingly looking towards private markets and real assets, which are often quite illiquid, as they seek to manage inflation and the effect of rising rates on traditional asset markets.
There are two problems we see with illiquid alternatives, such as private equity, property and venture capital.
Firstly, they have yet to mark down. With stocks and bonds down so much, it has artificially inflated the proportion of their intended allocation to private investments.
This can give the illusion of resilience. However, when private assets mark down, investors might realise that they are not as diversified as their infrequent pricing has led them to believe.
Consequently, if investors realise that these assets are not as diversified as they originally thought, they might find they struggle to sell them to find real diversification.
This is where liquid alternatives can prove to be attractive. Different types of liquid alternatives produce structurally different alphas, offering different kinds of diversification and independent sources of risk.
If structured correctly, they can exhibit little correlation to stocks and bonds, with liquidity as needed.
As we move further into the second half of 2022, we believe economic and market conditions could get worse before they get better.
With a strong inflationary backdrop for economies and markets, we see this as an attractive opportunity for trend-following strategies.
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Inflation is effectively an auto-correlation in prices — something that trend-following strategies are specifically designed to capture.
Alternatives are a constantly evolving part of the investment industry and new ideas or opportunities are implicit in the growth of the alternatives universe.
It can be well worth the effort to consider the potential role that alternatives can play in a balanced portfolio in such uncertain times.
What you see is what you get
Typically, alternative allocations are regarded as satellite investments within a portfolio predominantly exposed to traditional equity and fixed-income volatility.
However, by leaving alternatives as a solely peripheral investment, the strong diversification that alternatives can offer can realistically only help to mitigate the risks presented by a core allocation to equities and bonds.
It is likely that a more significant allocation would be required to achieve stronger diversification benefits.
Alistair Sayer is client portfolio manager at Janus Henderson Investors, a member of The Gulf Capital Market Association