Faced with an investment environment increasingly driven by politics and a longer-term trend towards all things digital, traditional asset allocation has become a relic of the past and greater patience is needed to ride out volatility. How does one face these challenges? I follow an investment approach that focuses on five pillars.
Macroeconomic and investment environment analysis
What are the major trends that will shape capital markets in the coming years, and how will those trends affect asset returns in the context of the chosen investment horizon? This is the first question I ask myself before embarking on the asset allocation journey. The aim is to understand the direction ‘‘gravity’’ is pulling asset prices: investor portfolios should include assets that would profit from secular tailwinds. Inflation, growth and interest rate expectations, as well as technological developments and geopolitical factors are all relevant topics.
Strategic asset allocation
A strategic asset allocation is an investor’s benchmark allocation. It reflects their risk appetite, preferred investment horizon and major secular trends. The SAA should be tailored to match an investor’s financial goals and ability to withstand the expected investment environment. What is crucial to understand is that the SAA, and not cash, is an investor’s default position. When there is market turmoil, fleeing into cash can be extremely costly – market timing has time and again proved to be a futile exercise. Once out, investors are unlikely to re-enter the market at the right time and tend to miss the rallies that follow.
Tactical asset allocation
In the shorter term, when the immediate outlook for certain asset and sub-asset classes changes, investors may want to stray from their chosen SAA to take advantage of deviations from long-term trends. As the economy accelerates and decelerates, cyclical stocks such as industrials and consumer discretionary tend to, respectively, outperform and underperform the rest of the market. Thus, in accordance with the market cycle, investors may want to increase and/or reduce their exposure to these particular stocks.
However, tactical moves are not always straightforward to implement. This is especially true nowadays as market signals are blurred by political noise.
For example, how should investors navigate something as unpredictable as a trade war, in which the rules of the game can be altered at any moment?
Our approach provides a framework to tackle active tactical investment in this environment. Political factors, such as Brexit or the China-US trade dispute, are considered an external shock and are, by definition, unpredictable. In such situations, investors overreact and the framework suggests to buy risk assets as the risk premium spikes.
When examining tactical moves, to complement the qualitative analysis, I make use of quantitative indicators, which help me to better understand what’s happening in markets. By combining a sound and disciplined judgmental approach with a review of market indicators, market action can be analysed in the context of the broader investment environment in which we operate.
Portfolio construction and implementation
One of the beauties of investing is that different assets do not behave in isolation. They are intricately interconnected and present different correlations in distinct situations over varying time horizons – and play specific roles in an investor’s portfolio.
There is the textbook case of bonds and equities, which, since 1998, are negatively correlated in the short term, providing diversification in turbulent times (although this fundamental investment principle has proven not so reliable in this era of ultra-low interest rates).
As if it wasn’t complex enough, investors also have to decide how much credit or duration risk is appropriate. They need to take into account currency risk and be mindful of how equity factors such as cyclicality or momentum affect their portfolios, among many other considerations. Equally important is the instruments used to implement the portfolio and the choice between an active or passive, systematic or judgmental approach in the implementation. Studying these relationships and applying them in a portfolio to achieve an investor’s goals is what constitutes portfolio construction. It is an exercise that lies at the frontier between art and science.
One of my fundamental investment beliefs is that portfolio construction is key, and much time and effort should be dedicated to ensuring that it meets objectives.
Risk management
A portfolio is not a static entity frozen in time. As markets move, some up, some down, so do portfolio weights, factor and risk exposures. Consequently, to meet an investor’s return and risk targets, the portfolio must be monitored and adjusted if needed. Keeping a close eye on systematic and specific risk factors and tracking errors versus benchmark is part of it. This step of the process can be difficult to achieve for some individual investors and advice from an investment professional can often help.
Yves Bonzon is the group chief investment officer of Julius Baer
