How to drive real returns
Today’s investment backdrop is dominated by low bond yields and sluggish growth. In this article, we discuss how investors can materially improve the potential for superior return outcomes.
Adopt a flexible approach to asset allocation
Unlike short-term trading, dynamic asset allocation is about the next few years and what current market conditions imply for returns over that period. This is far more than simply saying something is cheap or expensive and assuming some sort of reversion to a long-term valuation. It requires an awareness of the cycle, liquidity and investor sentiment.
Global market returns have historically been defined by longer term ‘secular’ cycles lasting circa five to 20-years, and shorter-term business and market cycles lasting approximately one to five years. Each long-term cycle is normally born in a crisis and driven by a period of rapid innovation or productivity, and ends in a ‘blow out’ in valuations and excess exuberance.
Within these longer cycles there are always business and market cycles as well, where valuations, cyclical trends and investor emotion drive markets. In a bull market, these trends tend to get muffled, but in a bear market they are stark and present an enormous opportunity to an active investor.
Introduce greater diversity
One of the most advantageous additions to a portfolio is to have investments that are truly diversified. Markets offer diversification benefits to a point, but ultimately they tend to cluster around economic conditions. If growth is strong then credit and equities do well, if growth is weak bonds generally perform well.
Identifying and gaining adequate exposure to ‘alternative’ return sources provides a rich vein of returns that should always improve portfolio outcomes, but in a low growth world offer additional potential value.
Direct assets such as private equity or infrastructure are one avenue, albeit with loss of liquidity. These assets do offer more diversification given they are more about the actual asset and manager than about a broad market, but they are also affected by cycles, the ride is typically smoother because pricing and transactions are slower.
Another source of returns are in alternative strategies, or finding opportunities that offer good return potential but are much less dependent on markets. Investors need to be wary of alternative strategies that aren’t persistent, are arbitraged away or simply too expensive to capture.
Consider the notion of value
Most investors around the world incorporate the idea of buying ‘cheaper’ stocks. Academic studies identify ‘value’ as a persistent return factor, whereby consistently buying cheap stocks and not owning expensive stocks yields a premium in return over the broader market.
The idea is that there are always dislocations and opportunities in markets that can provide excess return potential. Examples abound, particularly when liquidity has left smaller markets, think:
- Inflation linked bonds in 2008;
- Leveraged loans or convertible bonds in 2009;
- Peripheral European debt in 2012;
- Non-agency mortgages in 2012 and 2013.
On occasion the dislocation can be very fast, US Treasuries in October 2014 provided a very brief opportunity to react with an intraday crash that lasted minutes.
Some tips for investors
Given the outlook for returns over the medium term, investors – particularly those in or nearing retirement – can take steps to help ensure their investment portfolio seeks to deliver the real returns they need to support their retirement income.
- Have reasonable return expectations
- Be prepared to take more risk in order to receive higher returns
- Ensure investments are diversified
- Look for investments that are flexible in their approach and are actively managed
About the author
Matthew Hopkins is a Senior Portfolio Manager, Multi-Asset Group, at AMP Capital