Having grown in popularity during a long bull market, most multi-asset strategies have yet to be fully tested. Baillie Gifford investment manager James Squires argues that could be about to change, and that it will be the well-diversified, flexible approaches that will be most valuable to investors.
A striking feature of the recent growth of multi-asset investment strategies is that it has come in an environment not wholly favourable to such approaches.
Multi-asset funds were designed primarily to give investors access to active investment across a full range of asset classes, offering diversification – and providing attractive, low-volatility returns through the investment cycle. However, the sector has grown in popularity during a period characterised by strong equity returns, strong bond returns and low volatility. Unusually, equity and bond returns have moved up in lockstep, rather than with their traditional balance and offset. And, while some multi-asset funds – including Baillie Gifford’s Diversified Growth strategy – have produced strong track records over more than ten years, performance across the sector has varied.
The merits of the sector have come under scrutiny. Several, high-profile funds have struggled, and performance has generally undershot strongly performing equity markets. Some investors expect equity-like returns and are now disappointed at the shortfall. But the cash-plus returns that multi-asset strategies typically aim for represent quite different objectives - attractive returns at low volatility over the long run. Few multi-asset strategies have yet gone through a full economic cycle and so we should not be surprised that returns have trailed the best-performing asset class during such a strong period for economically exposed assets.
The coming decade is likely to look different to the past decade, which has been characterised by above-trend global growth, recovery from low valuations and unprecedented monetary support from central banks. This has not been a ‘normal’ period. To give one example, over the past decade, US equities have posted annualised returns of just over 12% (above the prevailing cash rate), a stark contrast with the 5% (over cash) annualised returns of the preceding 80 years.
Today bonds and some regional equity markets appear expensive by historical standards, even as growth indicators have nudged downwards on threats that include a US-China trade war, Brexit and the stagnation of the German economy. At the same time the options open to central banks have narrowed further. Low inflation has enabled the unprecedented levels of monetary support in recent years, yet with low unemployment a feature in most major economies, it seems probable that inflation will eventually increase and central banks’ room for manoeuvre will lessen.
As we approach the next stage of the investment cycle, there is an opportunity for multi-asset managers in general, and Baillie Gifford in particular, to restate what we think we do well.
Baillie Gifford’s philosophy has two core principles:
Firstly, we seek as wide as possible an opportunity set, encompassing both traditional asset classes such as bonds and equities and also alternative asset classes such as infrastructure, commodities, emerging market debt, structured finance, and currencies. We add value not just by operating across this broad range of asset classes, but also by active stock selection within the asset classes.
What we choose to own within an asset class is important. Infrastructure is a good example. Some infrastructure is essential to a country’s everyday functioning such as power lines, gas pipelines, hospitals and the public-private partnerships that build them. But a broad description of infrastructure also includes more economically sensitive assets such as airports, ports and toll roads. This latter category is vulnerable to economic downturns, while the former has the potential to offer reliable returns regardless of the broader environment, delivering the low-volatility and diversifying returns we seek for our funds.
Secondly, we have the flexibility to own more of an asset class when it is cheap, and less when it is expensive. We will tend to have substantially larger holdings in asset classes when they appear to be trading below their long-term fair value and to sell them when they appear expensive. With few constraints and no strategic benchmark, we can sell out of a particular asset class altogether if we consider it prudent.
We do not seek to dramatically change the portfolio around month-to-month, or in response to short-term economic factors, so our flexibility and active management should not be mistaken for a high turnover approach. Rather our portfolio allocation is underpinned by long-term fundamental research and a deep understanding of the asset classes in which we invest. Our funds are invested in the very best long-term opportunities we find, also taking advantage of substantial valuation changes and market opportunities. For example, our aggregate exposure to credit market has ranged from 5% to 45% in recent years.
We spend a lot of time analysing possible scenarios and on understanding how different asset classes would behave and correlations would change in such a scenario.
This forward-looking analysis forces us to consider possibilities outside our central view, to identify potential opportunities and threats, and enables us to build appropriate protection into our portfolios.
Identifying risks and considering sensible hedges is important. We look for cheap hedges that offset specific risks, and more broadly will position the portfolio more cautiously when risk is high and rewards are scant. Presently, we are concerned about tensions in the Middle East and have included exposure to oil, an asset we expect to rise sharply in price if tensions escalate in oil-exporting countries. More broadly, our concerns about trade tensions and the potential impact on growth are reflected by maintaining a lower exposure to economically exposed assets, and by holding currency positions that should deliver particularly strongly if trade outcomes disappoint.
Ultimately, investors look to multi-asset strategies to provide portfolio growth with low volatility over the long term. We currently see several exciting opportunities for such growth. One is in emerging market bonds, where the high real yields on offer from a set of countries with faster growth and lower debt than the G4 regions (Eurozone, Japan, US and UK) look hugely attractive. Nickel presents a similarly compelling story. The metal is a key component in the lithium-ion batteries used to power electric vehicles and we believe there is an undersupply relative to the growth in demand. That’s likely to remain the case as the electric vehicle market grows, pointing to nickel prices moving even higher to incentivise production.
Multi-asset for the next decade
The multi-asset universe has expanded during an unusually benign period in which strong growth and asset class returns have not always been closely aligned. The coming period may present stiffer challenges. In that environment, the ability of multi-asset funds both to provide downside protection and to take advantage of the return opportunities outside of the traditional asset classes will likely prove increasingly valuable.
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