By Nick Horton
A large number of institutional investors have allocated to multi-asset approaches in recent years. The period after the financial crisis was ideal for multi-asset investors, however in the future those managers that have flexible investment processes and effectively control correlation risk will be better placed to provide strong risk-adjusted returns.
The multi-asset universe is heterogeneous. The common link, however, is that the fund managers aim to improve the distribution of returns delivered to an investor through substituting equity risk with a range of other risk factors such as credit risk, duration risk, commodity risk and others, in combination with manager skill. Limiting downside through diversification enables investors to compound capital at a higher rate and, in the long term, achieve a performance similar to the one expected from an equity exposure but with significantly lower volatility.
As multi-asset funds typically invest in a broad range of markets in a directional manner, they are exposed to risk factors that may disappoint in the short term. This is particularly true when risk aversion dominates and correlations increase resulting in higher risk. In times of stress correlations increase, reducing diversification benefits. Therefore, one of the key risks multi-asset managers take on is correlation risk, and how this is managed is vital to their success.
In a normal market environment, asset classes exhibit different risk and return profiles and investors expect to be compensated with a higher rate of return for exposure to riskier assets. This forms the typical efficient frontier with lower risk assets such as bonds producing lower returns than higher risk assets such as equities. However, the unprecedented monetary stimulus from central banks since 2009 has distorted the efficient frontier increasing all asset prices and correlations. During this period, low beta assets and high beta assets both performed very well thanks to the intended objective of quantitative easing: inflating asset prices to stimulate the economy. With valuations now looking extended for most asset classes, valuations will have to go from expensive to very expensive for most multi- asset funds to continue providing these attractive returns. This may take place, however we don’t believe managers can rely on this possibility. Instead, we believe that those multi-asset strategies with a flexible approach that can utilise the full spectrum of asset classes – both long and short – will be better placed to benefit from relative value opportunities within and between asset classes.
The outcome and consequences of central bank policy decisions are wide ranging and uncertain. Given the scale of intervention the outcome is likely to be exacerbated and could be inflationary or deflationary. Maintaining a flexible multi- asset approach with a long-term investment horizon is a good way to benefit and protect against any likely policy error. However, when choosing a multi-asset strategy it is vital for investors to understand how the manager allocates to assets and controls correlation risk. In addition, we believe that the key to a successful multi-asset strategy in the future will be its ability to invest in a flexible unconstrained manner and act idiosyncratically to broaden specific risk exposures.
Nick Horton is a partner at Dalton Strategic Partnership
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