In today’s environment, multi-asset strategies remain an indispensable tool for gaining flexibility and diversification. But what elements make it possible to differentiate a multi-asset strategy from its competitors? Cristophe Machu, from the Multi Asset and Convertibles’ team of investment specialists at M&G Investments, explains in detail the approach used by the M&G Dynamic Allocation and the M&G Prudent Allocation strategies, which seek to convert market overreactions into a source of returns for the investor.
Both funds use an approach composed of three different pillars: strategic valuation, tactical valuation and portfolio construction. During the first block, strategic valuation, the management team examines and compares the valuations of the different asset classes in which the strategy invests – equities, fixed income, and currencies – with their fundamentals, to ensure the correct allocation of assets, which will be the portfolio’s main source of alpha. In the second block, tactical allocation, the management team seeks to exploit the opportunities that are generated in terms of volatility from changes in investor sentiment. According to M&G, on average, 18% of market volatility is the result of an excess of optimism or pessimism in investor sentiment, something that affects valuations, but not fundamentals. Finally, in portfolio construction, they focus on finding sources of decorrelation between the different assets. According to M&G, the correlations are not static, which is why they must perform a qualitative analysis over quantitative analysis, in order to understand the degree of correlation that future portfolio assets can reach.
Why is Strategic Valuation the Starting Point?
Returning to the first pillar, Cristophe points out that valuation is a good indicator of future returns, as it allows us to know what returns are expected of an asset and how it is being perceived by investors in the market. In equities, in both the United States and Europe, the current level of the forward P/E multiples can show the expected average yield over five years. Therefore, if you buy shares with multiples between 8 and 10 times, in five years you could realize an annualized yield of 20%. However, if you pay too much for an asset, with multiples between 24 and 26 times, the investor would almost certainly incur a loss.
A second issue that M&G evaluates, in order to try to take advantage of the opportunities it generates in the medium term, is the evolution of market volatility. In this respect, the managers of the multi-asset strategies would try to detect «episodes», or moments in which quotes for the assets don’t correspond with their fundamentals to add risk to the portfolio. This alternative investment approach, with some contrarian vocation, tries to play tactically with asset allocation, increasing equity exposure when the market is over selling its positions for no apparent good reason. The strategies that follow this approach are called «Episode strategy».
A good example of this approach is the returns obtained by the M&G Dynamic Allocation fund, which invests around 40% in US equities, compared to the performance of the S&P500 index and to a multi-asset portfolio that starts from the same allocation in US stocks, but that uses stop-loss mechanisms whenever the market experiences a fall, progressively reducing its exposure to risky assets with each decline. Over a period of 20 years, the returns of the M&G strategy would have been substantially higher than those of the market and of the strategy using stop-loss mechanisms, exceeding them by 60% and 108%, respectively.
Why is it Pointless to Try to Predict the Future?
2016 was a year full of political events, during which the difficulty of guessing when making predictions became quite clear. Many investors were surprised by the vote in favor of Brexit and by Donald Trump’s election as president of the United States. For Cristophe, the most surprising thing about that whole case is that, even knowing the final result, it is still possible to err when reading the expected market reaction. Some market experts anticipated that a Trump victory could mean a precipitous decline in the markets and the beginning of a recession. Far from these predictions, in the weeks following the November election, so-called safe haven assets, gold and Treasury bonds at 10 and 30 years yielded negative returns, while the S&P 500 index performed positively. That is why, in terms of tactical management, none of the asset managers at M&G tries to make predictions, but rather, to benefit from the volatility that different episodes or market events can create.
In this regard, the VIX volatility index could serve as an entry indicator into the equity market, because according to the M&G investment specialist, after a peak of volatility in the VIX, the S&P500 usually experiences a rally in the following years, showing adequate moments for the incorporation of greater exposure to risky assets in the strategies.
Cristophe also points to the purchase by the M&G Dynamic Allocation fund of European, US, British, and Japanese stocks during the months of January and February 2016 as an example of a response to a market «episode», to then undo these tactical positions in March. Months later, after Brexit, the fund took advantage of the attractive valuations of the banking sector and of certain regions to increase its exposure to these assets. It then sold those positions as soon as the market moved sideways in September of the same year.
The Importance of Correlations Between Assets
At M&G, they argue that the correlation between equities and fixed income is dynamic and depends on the bond yield. If the bond yields are quite high, close to 10% or higher, there is usually a good source of bond and equity decorrelation. On the other hand, if the bond yields are much lower, below 5%, the ratio between the two assets is positive. This means that, at present, adding fixed income is not as attractive as equities, neither from a valuation point of view nor as a source of decorrelationas compared to equities, therefore, at M&G they do not believe that investing in a traditional multi-asset fund is the right solution for the client
Where is the Value?
Both the M&G Dynamic Allocation fund and the M&G Prudent Allocation fund can take short positions in equities and fixed income. In response to the cycle of interest rate hikes by the Fed, the fund positions itself with a negative duration.
The bond market is in an anomalous situation, where yields remain extremely low in both the United States and the United Kingdom, as well as in Europe and Japan. Taking inflation into account, these bonds have a negative yield, implying that an investor is willing to lose money in the medium term by investing in this type of assets. That is why the fund seeks to generate profitability by positioning itself short in relation to the debt of these countries.
Furthermore, at M&G they believe that, in US corporate credit, specifically in the BBB-rated universe, there may be value, as well as in some emerging markets, such as Brazil, Colombia and Mexico, which offer attractive spreads with respect to US Treasury bonds.
In equities, price is determined by the product of corporate profits and market valuations in terms of P/E multiples. In this regard, at M&G they strive to find sectors or geographical areas that can offer an increase in terms of corporate profits or whose valuations have potential for appreciation. Emerging markets and European equities would have these characteristics, and they hold long positions in both markets. While in the United States, although corporate profits are high, valuations are at their highest, so they hold long positions in some sectors with attractive valuations such as banking, technology, biotechnology, and oil, but for the first time in the fund’s history, they hold a net short position in US equities.
Finally, in the area of foreign exchange, M&G’s multi-asset fund managers prefer emerging market currencies for two reasons: the attractive valuation level of the Turkish Lira, the Russian Ruble, the Mexican Peso and the Brazilian Real, and the carry that these currencies represent against the dollar.