A generational shift in portfolio design

Given the challenging economic environment and the hard lessons of the past several years, investment professionals need to…

Given the challenging economic environment and the hard lessons of the past several years, investment professionals need to rethink risk/return opportunities and portfolio construction.

Post-2008, markets are filled with complexities and risks that yesterday’s investor couldn’t have imagined: sharply higher market volatility, an increasingly interconnected global economy, higher correlations among many asset classes, and interrelated questions about the solvency of sovereign-debt issuers and financial institutions, among others. Successful portfolio management today must reflect a forward-looking view of the covariance between asset classes.

Based on consensus forecasts, the nominal rate of return over the next three to five years is expected to be about 5% for stocks, 3% for bonds and 0% for cash.

We think that risks remain tilted toward the downside, given that the world hasn’t truly deleveraged but merely has shifted the debt problem from the private to the public sector. Outcomes for long-term investments will be driven both by fundamentals and by macroeconomic factors.

Although alternative investments may provide some shelter from downside equity risk, one can’t simply assume that “noncorrelated” will equal superior risk-adjusted rates of return.

There must also be an expectation that the return premium will exceed both equity and bond proxies, after fees. If not, a risk-averse investor is likely better served by medium- to longer-term U.S. Treasury portfolios and some form of insurance.

We think that each investor’s core investment strategy should use top-down, fundamental and macroeconomic research to build a portfolio around five key segments: systematic beta, global macro, liability-driven, relative value and pure alternatives.

Let’s look at each further.

Systematic beta. This portion of the portfolio uses common market factors to provide extra risk-adjusted return above the broad global equity market and should reflect both the cost and potential alpha of specific securities. Currently, this should include an allocation to global dividend-paying stocks. In general, such companies regularly raise their dividend, have a history of strong operating cash flow, are well-capitalized and usually generate annual sales revenue from global sources. The strategies deployed for this segment also should mitigate some of the expected volatility of long-only equity.

Global macro. This somewhat more tactical segment is driven by top-down investment ideas, and uses our 12- to 24-month market forecasts to take advantage of perceived mispricing in the marketplace. We think that allocations to global infrastructure and health care stocks, gold bullion, emerging-markets equities, global real estate investment trusts and U.S. dollar-denominated assets are appropriate.

Liability-driven investments. This portion of the portfolio follows the asset/liability match for the client, with investments held in various maturity tranches of U.S. Treasury securities. This low-cost, risk-averse approach can help immunize the portfolio from shortfall risk, i.e., the risk of the investor’s not meeting a longer-term objective.

Relative value. This segment of the portfolio captures idiosyncratic, security-specific contributions. This can take a variety of forms, including active security selection, sector emphasis, pairs trading and capital structure arbitrage. In our current thinking, credit risk in the global fixed-income arena provides substantial opportunity for active management in the mortgage, credit, sovereign and emerging-markets components of debt allocations within the portfolio.

Alternative investments. The decision to invest in alternatives is similar to that involving any other asset. Here, too, it is shortsighted to focus only on historical correlation and not expected return versus risk and correlation. Currently, we include portfolio positions in the following areas: multistrategy (low volatility), multistrategy (higher volatility), long/short credit (debt arbitrage), managed futures, long/ short equity and arbitrage (equity-market-neutral).

The financial landscape of just a few years ago no longer exists, and the old rules of thumb no longer work the way they used to. These new realities require fresh thinking and innovative methods to evaluate potential risk and reward properly, and to structure portfolios accordingly.

Investment professionals who fail to recognize this run the risk of being a Remington typewriter in an iPad world.

Don Robinson is chief executive and co-chief investment officer of Palladiem LLC, a registered investment adviser.