Goals-Based Investing

3 key strategies to enhance portfolio performance in a low-return world

By Matthew Hopkins
Sydney, Australia

Regardless of what one believes about the future, it is likely that diversified investment returns are going to be lower over the next few years than what they have averaged over the last couple of decades. Lower starting point yields are evidence of this. This article explores some of the opportunities and strategies available to help investors achieve real returns in the current environment.

Investors have enjoyed solid returns in recent years. Post-global financial crisis monetary policy has provided a tailwind for markets. But that cycle is now turning. We feel that equity markets are fully valued and rates and yields are rising, though remaining at historically low levels.

Investors must accept that forward returns will be lower, particularly for income and lower risk funds with greater exposure to bonds and cash.

In response, some fund managers may move to lower investor expectations or extend the time horizons of their portfolios.

But we believe that how we manage our portfolio is just as important. In our view there are three key areas where portfolio managers can improve the potential for return outcomes in this low-return environment.

1. Increase flexibility of asset allocation – adopting a more dynamic process to respond to changing expectations

The first area is dynamic asset allocation, which allows investors to exploit short-term cycles.

Global market returns have historically been defined by longer term ‘secular’ cycles lasting 5-20 years, and shorter-term business and market cycles lasting approximately 1-5 years.

Each long-term cycle is normally born in a crisis, driven by a period of rapid innovation or productivity and ends in a ‘blow out’ in valuations and excess exuberance.

But within these longer cycles there are always business and market cycles as well, where valuations, cyclical trends and investor emotion drive markets. In a bull market these factors tend to get muffled, but in a bear market they are stark and can provide an enormous opportunity relative to the passive long-term investor.

When we talk about dynamic asset allocation we don’t mean short-term trading. We are talking about a timeframe of a few years and what current market conditions imply for returns over that period. Dynamic asset allocation is far more than simply saying something is cheap or expensive and assuming some sort of reversion to a long-term valuation. It means being aware of and reflecting the cycle, liquidity and investor sentiment.

When yields were higher, investors had a greater probability of achieving their targets and therefore had less incentive to actually do anything differently. It was less important how investors allocated assets because the additional value added was a smaller component of the final return. But today any additional value-add, particularly through dynamic asset allocation, could potentially be a much larger component of the total.

2. Search for other return sources to introduce greater diversity

Another way to potentially improve return outcomes in this low-return environment is to increase a portfolio’s footprint in sources of alternative returns.

Alternative investments can provide a rich vein of potential returns that may improve expected portfolio outcomes. In a low-return world they are relatively more attractive than otherwise.

One of the best ways to enhance a portfolio is to have truly diversified investments. Markets do offer diversification benefits to a point. But ultimately, they tend to cluster around economic drivers. Generally speaking if growth is strong then credit and equities do well, if growth is weak bonds do well.

Alternative assets, for example, including direct assets – like private equity or infrastructure – offer greater diversification because they are more about the actual asset and manager than about a broad market. They do often offer less liquidity and can also be affected by market conditions, but the ride is smoother (normally) because pricing and transactions are slower.

Another source of returns is moving from a world of direct holdings (what do I buy with my cash?) to a relative world (what I can hold relative to something else?).

There are many different types of alternative strategies that can be accessed in global markets. Identifying those that can be profitable, and when, is the challenge. Avoiding those that aren’t persistent, are arbitraged away, or are simply too expensive to capture, is the challenge to be overcome.

3. Be Opportunistic

The third – and perhaps the hardest solution -- is to simply be more opportunistic.

There are always dislocations and opportunities in markets that can provide investors with the potential to earn excess returns.

Examples abound, particularly when liquidity has left smaller markets. Think inflation-linked bonds in 2008; leveraged loans or convertible bonds in 2009; peripheral European debt in 2012; and non-agency mortgages in 2012 and 2013.

Some markets get crushed when everyone has to exit and there is no natural buyer except the brave and well informed. Oil volatility, for example, rose spectacularly in the third quarter of 2015 after a period of relative stability. On occasion the dislocation can be very fast, such as when US Treasuries in October 2014 provided a very brief opportunity to react with an intraday crash that lasted minutes.

To allow differentiated opportunities to get into portfolios, the way investment managers work with clients and with each other is evolving. We are already seeing this with ‘partnering’ becoming an increasingly common term. The idea is that we work with external specialists to bring ideas and insights that can be implemented quickly in a portfolio, rather than tie capital up with one manager waiting for opportunities to come along. 

Empowering investors

The effectiveness of these three strategies rises with the flexibility allowed in the portfolio construction. We believe that a holistically managed portfolio with few constraints around peers or benchmark exposures, and more flexibility with fees, has a greater ability to implement them than a passively managed fund in a peer survey.

The flip side however, is that the greater the application of these strategies, the more a manager or company must invest in appropriately skilled staff, due diligence, systems and governance.

In this low-return environment, there is no doubt that investors need to have reasonable expectations of likely returns. But it is also true that the three strategies described above do offer investors the potential to enhance return and especially so in a lower return environment.

 

If you would like to know more about AMP Capital's goals-based approach to investing, please visit Goals-based Investing.

 

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Important notes

While every care has been taken in the preparation of this article, AMP Capital Investors Limited (ABN 59 001 777 591, AFSL 232497) and AMP Capital Funds Management Limited (ABN 15 159 557 721, AFSL 426455)  (AMP Capital) makes no representations or warranties as to the accuracy or completeness of any statement in it including, without limitation, any forecasts. Past performance is not a reliable indicator of future performance. This article has been prepared for the purpose of providing general information, without taking account of any particular investor’s objectives, financial situation or needs. An investor should, before making any investment decisions, consider the appropriateness of the information in this article, and seek professional advice, having regard to the investor’s objectives, financial situation and needs. This article is solely for the use of the party to whom it is provided and must not be provided to any other person or entity without the express written consent of AMP Capital.

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