In the current financial crisis, mainly triggered by the sovereign debt crisis in Europe and the debt ceiling issue in the US, uncertainty, nerves and fear are driving market volatility, and building portfolios for investors is not an easy task.
What is the best strategy? Is it to try and step back from the short-term chaos and focus on the back-to-basics, fundamental trades? Or is it about preserving capital? And are these two concepts in conflict with each other?
“Today, portfolio management is about weathering the storm and preserving capital rather than searching for yield,” says Markus Taubert, head of private banking at Hamburg-based Berenberg Bank.
This approach may not lead to an optimal portfolio allocation today, he says, but to keep on buying and holding investments is no longer possible. “You definitely have to implement a tactical allocation to adapt to the market turmoil,” he says.
In these macro-driven markets, where stocks, in particular, are not moving in line with fundamentals, the only solution is to reduce risky assets. “Over the past two to three months, we have reduced our equity quota by 50 per cent, mainly in the eurozone,” says Mr Taubert.
In this extended period of uncertainty, it is also important to focus on so-called safe haven assets, even if they are “highly overvalued”, such as government bond markets in Europe.
And volatility is not a bad thing, explains Mr Taubert. “We are protecting portfolios either by buying put options or selling call options.”
But even in a crisis, it is important to stick to the principle in portfolio management of dividing clients’ wealth into two different pockets, one invested in liquid assets for short-term needs, and the other allocated to more illiquid assets to meet client needs in the longer term.
The proportion of a client’s portfolio that can be invested into illiquid assets varies greatly on client needs. It can be as low as 5 per cent up to a maximum of 30-50 per cent. In addition to private equity, real assets such as infrastructure, property, forest, agricultural investments or shipping are attractive and can generate “great returns” over the longer term. Real assets are also a valid hedge against inflation.
“In a moment in time like now, it is probably best to really focus on covering your bets,” argues Thomas Becket, CIO of Psigma Investment Management. “I don’t think it’s a time to be taking extreme asset allocation moves in any direction.”
Given the unprecedented number of outcomes that are possible from the current market chaos, investors need to embrace the concept of portfolio diversification now more than ever, while also looking beyond the crisis, he says.
“My general thesis at the moment is to really try and encourage investors and clients to see through the current nonsense that is happening in markets and focus on those fundamental themes or investments that can really generate the best possible returns over the next five years,” says Mr Becket. “Trying to second guess what might happen in markets in the next five weeks or months is really difficult.”
These investments should be a mixture of relatively defensive low volatility trades. “Our key trade would be short duration high yield corporate credit,” he says. After the recent sell off in high yield credit markets, these are attractive, particularly now that 10-year German Bunds and US Treasuries are trading below 2 per cent.
Inflation protection is also important. While government index linked bonds have benefited from the flight to safety and now they look pretty expensive, high quality corporate inflation linked issues are more appealing. “You can get an attractive pickup in a corporate inflation linked market, which will ultimately give you better protection than government bonds over the next five years or so. If we do get an inflation spike, you will see government index linked bonds potentially suffer,” says Mr Becket.
Focusing on asset classes that can offer the best recovery potential is also a good strategy. The best value equity market in the world is the Japanese market, according to Mr Becket. “Japan has been a disastrous investment for the last 10 years but I think it might have better prospects going forward.” Japan is attractive because it almost offers an asymmetrical pay off. “I would estimate that the upside for Japanese equities is 100 per cent, whilst the downside is probably only 10 per cent over the next five years or so.”
The recovery theme in equity markets could also be seen in other markets around the world, as good stocks have been sold off with bad stocks over the last few months.
Having been underweight in equities, moving to a neutral stance is the way forward, he says. “If you can really try and encourage your investors to have a longer term outlook, volatility presents opportunities, if market volatility picks up and you see asset pricing falling. Over the next five years, equities will almost definitely be the best investment, so maintaining a decent weighting is probably sensible.”
