As volatility increases throughout global markets and returns lower, investors are facing a turning point. Michael J. Kelly, CFA, global head of multi-asset at PineBridge Investments, explains why asset allocation -along with a dynamic approach- is more important than ever.

What is going on in markets now?

Today’s volatility is the result of forces that have been building for a while. For many years, the global savings rate was relatively stable. Then, just before the global financial crisis, it stepped up. We saw extreme caution from businesses, central banks, and investors. Far fewer people and institutions were investing.

This was one of the biggest ever tailwinds for financial assets. Too much money was chasing too few opportunities. Meanwhile, central banks were growing their balance sheets relative to global economic growth. So they’ve been adding liquidity on top of naturally formed liquidity – another huge tailwind for financial assets.

This caused a global liquidity surge, which caused many investors to lean on growth assets, weighing down prospective returns. However, this challenging market environment also created opportunity for investors who can selectively identify attractive insights and dynamically shift their investment mix.
 

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Looking ahead, what will this mean for investors?

Now is a good time for investors to start thinking ahead and realizing that the next several years won’t be easy. Unlike during the crisis, which was extremely painful but ended relatively quickly, this will be a slow drip. Expect more risk and not enough return to meet investors’ expectations. And the answer is not diversification alone, but optimal allocation across the investment universe while expressing convictions.

This brings me to asset allocation. This is the biggest decision in every portfolio. It’s not a new concept, but many investors still don’t pay it enough attention.

And that has been fine so far – investors have been playing it safe with few consequences – but the time is coming when markets will reach an inflection point, and investors will need to use asset allocation to help them navigate a world of much lower returns but continued high expectations.

What’s the danger for investors in playing it safe?

We’re entering a period of slowly rising interest rates, and it’s been a while since markets have had to deal with that. For a long time, we’ve been in markets dominated by falling interest rates. You can play it safe without much of a penalty in that world. In periods of disinflation, the correlation between capital conservation assets and growth assets becomes negative. The effectiveness of one to hedge the other goes up. So playing it safe has worked really well as rates have dropped.

But what happens when rates are no longer falling? They’re either flat or rising. While play-it-safe investing lowers the risk, it carries quite a penalty in returns. When inflation and rates are flat and rising, that negative correlation actually becomes positive. We have already started to see this, for instance, in the fourth quarter of 2015, as the market anticipated higher rates by the US Federal Reserve. The effectiveness of those two to balance each other out goes down while the cost goes up, since the differential of returns is much higher.

How can investors best position their portfolios in this environment?

We do see some opportunities, but to explain, let’s go back to the idea of diversification. If you own a little bit of everything in a market capitalization sense, that means you own the slope of our Capital Market Line (CML). The CML is our firm’s five-year forward-looking view into risk and return across the asset class spectrum. Right now we consider its slope to be disappointingly positive.

But there is a silver lining: The dispersion of dots around the line has widened over time, and it’s the widest we’ve seen since we began constructing the CML. This means that the upcoming period will have more winners and more losers. So for investors, it’s a matter of picking more of the winners and avoiding the losers – which, of course, is not as easy as it sounds.

How do you do that?

With more opportunistic investing along with an intermediate-term perspective. You need to be much more opportunistic if you’re going to deliver an outcome over a three-, five-, seven-, or 10-year horizon.

In a world of policy-distorted markets that have created this massive tailwind, we think it’s relatively easy as the environment unwinds to avoid the asset classes that have been helped the most, those that might have the biggest tailwind.

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How do you and your team approach asset allocation?

Our approach focuses on growth assets – trying to get growth-asset-like returns with 60% or less of the risk that normally accompanies them. We think the only way to do this is to be much more opportunistic in moving between markets and between growth assets, shifting between growth and capital conservation when necessary. That shift, in fact, can sometimes be as dynamic as a rotation, which we witnessed in the financial crisis.

So I believe in a balance of approaches. But there’s going to be really no alternative in a lower return world with flat or rising rates to being more opportunistic in the growth assets that you pursue. We expect this to lead to investors’ “scavenging” for alpha, which presents its own challenges. The market has grown in terms of people looking for alpha within infrastructure, within stocks, within bonds. Before the crisis, looking for alpha between asset classes was basically talked about and not employed. How are investors gearing up to do that? The answer is not just getting more alpha out of security selection, but finding better, more efficient ways to allocate assets that provide a more consistent alpha source.

Opportunistic investments are providing the unexploited source of alpha to fill in the gap between market returns and investors’ expectations. In the current environment, everyone’s investing in more assets, in more areas of the world. So to get us to those windows of opportunity, we need to move more toward seeking returns through asset allocation.

This information is for educational purposes only and is not intended to serve as investment advice. This is not an offer to sell or solicitation of an offer to purchase any investment product or security. Any opinions provided should not be relied upon for investment decisions. Any opinions, projections, forecasts and forward-looking statements are speculative in nature; valid only as of the date hereof and are subject to change. PineBridge Investments is not soliciting or recommending any action based on this information.