Market volatility is expected to remain extremely high over coming months, correlation between asset classes’ returns is increasing and the concept of ‘safe haven’ investment has been called into question.
The priority is to protect investors’ portfolios from downside risk but also to try and take advantage of opportunities as they arise, often through a dynamic asset allocation process with no hesitation to scale down exposure to risky assets to a very low level. At UBP Private Banking, asset allocation to hedge funds has decreased to 10 per cent from the historical heights of 30 per cent, explains the bank’s chief investment officer Alan Mudie.
“We do believe that, by controlling risk-to-capital losses when markets are difficult, we preserve the possibility to move back into the markets and take large allocations when we see more opportunity,” he says.
By losing much less when the markets are tough, rather than making more money when markets are good, portfolios tend to outperform, says Mr Mudie. It is only human for risk aversion to rise as markets begin to fall and decrease as markets start to rise. “We tend to build portfolios in a way that avoids the discomfort clients can feel, when faced with sharply negative returns.”
This means also having to reduce exposure to illiquid strategies, although they have much higher potential returns. “The aversion to risk is currently very high,” says Mr Mudie. “Investors have brought down enormously their investment time horizons and are willing to lock-in a capital loss to have that liquidity offered by instruments such as very short term deposits.”
The converse is that there is a high degree of premium and pick-up in return potential for being willing to accept liquidity risk and to lock money in to strategies for a longer term horizon. These include hedge fund strategies, in particular those linked to securitised loans.
But taking liquidity risk is not the path Mr Mudie recommends. Portfolios at the Swiss private bank are pretty defensively positioned. The largest allocations, up to 25 per cent, depending on risk profile, are in non-financial short-dated high quality corporate bonds.
GOLD RUSH CONTINUES
Another major allocation is in gold, which for a balanced profile in an unconstrained portfolio is recommended to be 25 per cent. This is well above the typical 5 to 8 per cent allocation private banks recommend clients should have to this commodity, typically viewed as a hedge against inflation.
“We view gold as a core position, which we manage actively through the traded options market and, depending on the outlook and strategy, the writing of calls against our position. This provides a level of income which gold itself does not produce,” he says. Special accounts, forward contracts and, to a certain extent physically-backed gold ETFs, are the vehicles used to gain exposure to gold.
“Gold has a number of characteristics as a store of value, against the depreciation of currencies. It will ensure preservation of purchasing power and preservation of capital, given the very difficult outlook for the global economy and the systemic risk we see in financial markets.”
Demand for gold is outstripping supply and will drive the price of the commodity to reach new heights in dollar terms of over $2,000 (€1,560) per ounce this year, predicts Mr Mudie. This compares to the $1,650 as of mid January, having bounced back from a 10 per cent decline in December. Because of price volatility, investors who consider risk as being equivalent to volatility, will view it as a risky asset, he says. “But we think that risk for investors is the risk of capital loss and rather we try to take advantage of short-term volatility through option strategies.”
Lower quality or high yield bonds represent up to 8 per cent of assets in private portfolios at UBP. Looking at the implied default anticipation in today’s yield, the market is expecting on average around 10 per cent of the universe of high yield bonds to default on their payment of coupon and capital, each year for the next five years. Rating agencies such as Moody’s and S&P predict for 2012 around 2 to 2.5 per cent default in that market, he explains.
“With a pick of, depending on the currency, between 750 and 950 basis points over government bonds, there is a high degree of protection afforded by the high level of current income, and an overly pessimistic view as to the risk of default over the coming five years,” says Mr Mudie.
“Extremely high quality companies,” which have strong balance sheets and are also paying substantial dividends, are used as the “bedrock” of the allocation to equities, he says.
