Faced with an investment environment increasingly driven by politics and a longer-term trend towards all things digital, traditional asset allocation has become a relic of the past and greater patience is needed to ride out volatility. How to face these challenges? I follow an investment approach that focuses on five pillars.
Pillar I: Macroeconomic & Investment Environment Analysis
What are the major trends that will shape capital markets in the coming years, and how will those trends affect asset returns in the context of the chosen investment horizon? This is the first question I ask myself before embarking on the asset allocation journey. The aim is to understand in what direction ‘gravity’ is pulling asset prices: investor portfolios should include assets that would profit from secular tailwinds. Inflation, growth and interest rate expectations, as well as technological developments and geopolitical factors are all relevant topics.
We tackle these fundamental questions in the Julius Baer yearly Secular Outlook process, where senior research and investments experts come together to identify the key macroeconomic and capital market trends that will shape the next decade.
Pillar II: Strategic Asset Allocation
A Strategic Asset Allocation (SAA) is the investor’s benchmark allocation. It reflects his or her risk appetite, preferred investment horizon and major secular trends. The SAA should be tailored to match the investor’s financial goals and able to withstand the expected investment environment. What is crucial to understand is that the SAA, and not cash, is the investor’s default position. When there is market turmoil, fleeing into cash can be extremely costly – market timing has proved to be time and again a futile exercise. Once out, investors are unlikely to re-enter the market at the right time and tend to miss the rallies that follow.
100% of performance may be crystallised 20% of the time – yet investors need to spend 100% of their time in the market to capture these 20%.
Pillar III: Tactical Asset Allocation
In the shorter-term, when the immediate outlook for certain asset and sub-asset classes changes, investors may want to stray from their chosen SAA to take advantage of deviations from long-term trends. For example as the economy accelerated and decelerates, cyclical stocks such as industrials and consumer discretionary tend to, respectively, outperform and underperform the rest of the market. Thus, in accordance with the market cycle, investors may want to increase and/or reduce their exposure to these particular stocks.
Tactical moves are not always straightforward to implement however. This is especially true nowadays as market signals are blurred by political noise.
For example, how should investors navigate something as unpredictable as a trade war, where the rules of the game can be altered at any moment?
The Julius Baer Investment approach provides a useful framework to tackle active tactical investment in this environment. I distinguish 4 market regimes according to which, while investors stay fully invested most of the time (expansion), one can actively de-risk the portfolio when needed (systemic issue, economic contraction). Political factors, such as Brexit or the Sino-US trade war, are considered an external shock, by definition unpredictable. In such situations, investors overreact and the framework suggest to buy risk assets as the risk premium spikes.
When examining tactical moves, to complement the qualitative analysis, I make use of quantitative indicators which help better understand what’s happening on markets. By combining a sound and disciplined judgemental approach with a review of market indicators, market action can be analysed in the context of the broader investment environment in which we operate.
Pillar IV: Portfolio Construction and Implementation
A beauty of investing, or at least that’s how I like to think of it, is that different assets do not behave in isolation. They are intricately interconnected and present different correlations in distinct situations over varying time horizons – and thus play specific roles in an investor’s portfolio. There is the textbook case of bonds and equities, which, since 1998, are negatively correlated in the short-term, providing diversification in turbulent times (although this fundamental investment principle has proven not so reliable in this era of ultra-low interest rates). As if it wasn’t complex enough, investors also have to decide how much credit or duration risk is appropriate, they need to take into account currency risk and be mindful of how equity factors such as cyclicality or momentum affect their portfolios – among many other considerations. Equally important is the instruments used to implement the portfolio and the choice between an active or passive, systematic or judgemental approach in the implementation. Studying these relationships and applying them in a portfolio in order to achieve the investor’s goals is what constitutes portfolio construction. It is an exercise which lies at the frontier between art and science.
One of my fundamental investment beliefs is that portfolio construction is key, and much of time and effort should be dedicated to ensuring portfolio construction meets objectives.
Pillar V: Risk Management
A portfolio is not a static entity frozen in time. As markets move, some up, some down, so do portfolio weights, factor and risk exposures. Consequently, in order to meet the investor’s return and risk targets, the portfolio must be monitored and adjusted if need be. Keeping a close eye on systematic and specific risk factors and tracking errors versus benchmark is part of it. This step of the process is especially hard to achieve for an individual investor by himself, and is much more suited to be left to investment professionals
What lies ahead in the economy and financial markets? Our Group Chief Investment Officer explains.