By Dan Mikulskis
Investment objectives and constraints will vary among asset owners and individuals. For some, managing downside risk will be a priority, others will seek growth and there is another group focused on matching or meeting liabilities. In much of our work with defined benefit pension funds, investment strategy is heavily influenced by the need to meet liabilities and manage downside risk relative to liabilities.
However, there is clearly a group of investors with a primary focus on ‘hunting alpha’. Historically, investors have tended to be heavily allocated to equities, often actively managed. From our work with family offices, wealth funds, endowments and other institutions without those investment objective constraints – the question frequently focuses on the most effective way to generate a high level of returns (in as diversified a way as possible). This now means looking more broadly across the asset class spectrum.
Investors in equities have enjoyed excellent returns over recent decades, with both US and European equities enjoying real returns of almost 8% per annum for the 30-year period ending December 2015.
As many have argued, the picture may be somewhat different going forward. The economic and business conditions that led to the spectacular equity market performance of the 1990s may not be repeated; valuations look high according to certain metrics; and growth/inflation backdrop is fundamentally more stagnated than it has been for decades.
Fortunately, there are a large number of other asset classes and strategies available today that can play a role in a diversified, high return strategy. These include traditional return drivers such as actively or passively managed equity – as well as more diversified and alternative strategies in the liquid space, such as diversified beta. There is also an array of high returning illiquid strategies – including distressed debt, absolute and multi-class credit, opportunistic commercial property and SME lending.
If you are an institution managing an asset only portfolio with growth as a priority, we believe there are four key questions to consider when building the most effective portfolio for your needs.
– Are you making use of the wide spectrum of available asset classes, or is your portfolio biased to a particular risk premium, strategy or star fund manager?
– How much illiquidity can you tolerate and are you making the most of this ability to generate returns?
– Are your alpha-sources diversified – do your active managers complement each other in terms of style, and are you making use of alpha across the asset class spectrum?
– Do you have a preference for cash flow generating assets and strategies?
In the hunt for alpha, investors traditionally held equity-heavy portfolios, which have generally done well over recent years and decades. However, as is becoming more widely acknowledged, generating equivalent levels of return may be more challenging moving forward.
Is it possible to go after these kinds of returns without relying on equities, as well as the skill of equity managers? We certainly believe it is possible, if you are able to hold equities alongside other forms of high-returning investments. A particular focus should be on the blend of illiquid and credit-focused asset classes.
Dan Mikulskis is head of defined Benefit at Redington