Andrew Harmstone, head of the global balanced risk control strategy at Morgan Stanley Investment Management, looks at multi-asset investing in the context of the current volatile and inflationary environment.
Hiking enthusiasts understand the importance of wearing the right footwear given the terrain. Comfortable sneakers work just fine on the flats wending through the forest or around a lake. Hiking boots generally afford a sturdier tread for tougher terrain... But treadless sneakers in the downhill steeps on scree? The potential for a disastrous fall.
Investors too are faced with continually changing market conditions. In our years of active fund management, our team has invested during economic recessions and recoveries, momentum markets and bubbles, rising interest rate and inflationary environments. Not to mention those “black swan” events that can take even the most astute investors by surprise.
Diversification is good but not sufficient
Given the vicissitudes of the market, holding certain investments in certain markets could be potentially disastrous. Research shows that, in distressed markets, equities across the globe start to move together in lockstep. Equity-only managers have no recourse other than to reallocate between their equity holdings and cash. We have previously referred to this quandary as “rearranging the deck chairs on the Titanic.”
Fixed income is often viewed as a safer investment in volatile markets. But we have seen bond funds lose money, and they have historically delivered lower long-term performance than equity.
Diversification is often the pat answer to managing volatility. It entails building a portfolio with both equity and fixed income assets in some fixed proportion based on an investment horizon and risk profile. And it’s a good idea.
Until it isn’t.
In our minds, a passively managed portfolio no matter how diversified, fails to protect capital during significant market drawdowns. Imagine an investor holding a 70% equity/30% fixed portfolio: If the equity allocation is down -30% and fixed income is unchanged, simple maths indicates the total portfolio is still down -21%, i.e., bear territory.
In contrast, a multi-asset manager allocates across multiple asset classes that can be rearranged to manage risk. But in our view, there are two keys to managing a multi-asset portfolio successfully: One, that the manager is a truly active manager, and two, that they manage to a volatility target, not a benchmark.
Simply defined, multi-asset managers manage equity, fixed income and cash in the same portfolio. In our case (and others), we manage commodity-linked notes as well.
As we see it, diversification is only effective if a portfolio is actively managed. In our case, active management is a forward-looking exercise, and anticipating volatility events is the hallmark of a good investment approach. Yes, that means we are, in fact, trying to forecast the future. But not with tarot cards.
Our team of 18 investment professionals survey macroeconomic and geopolitical conditions across the globe to identify potential sources of risk that could arise. The goal is to adjust portfolio exposures before volatility strikes on what we see as an upcoming risk event.
On one level multi-asset managers are managing a multi-asset portfolio, but in truth, what they are really managing is volatility. Evaluating any investment relative to a benchmark is tricky: If the broader market is down -35% and a portfolio only -30%, the manager has in fact beaten their benchmark, which is great for the manager. The client, however, has still lost close to a third of their investment.
Benchmarking portfolios based on volatility, with the investment process beginning with risk is completely different.
Multi-asset portfolios: 2020
A multi-asset approach to investing often meets the needs of investors who are looking for less volatility in their core investments. As a core portfolio allocation for the former and as a holistic strategy for the latter. Over the years, we have come to understand that investors are often more concerned with keeping their money than with growing it aggressively. Having said that, we see that both high-net-worth and smaller investors do want to grow their money, but with less volatility and most importantly, with no surprises.
These investors (and others) realize that massive drawdowns have the potential to cause even the most sophisticated investors to sell at the bottom—often the biggest disaster of all. Multi asset funds have the ability to protect portfolios on a relative basis during the most volatile periods.
There has been an uptick in the popularity of multi-asset funds in Europe. According to a recent Lipper Alpha Insight, “Multi-Asset Is Dead – Long Live Multi-Asset!” “Given the fact that a number of investors are not willing, or allowed, to invest directly in the stock markets and/ or demand returns that are considerably higher than the returns from the bond markets, one doesn’t need to be a market wizard to predict that the assets in multi-asset funds will increase, as multi-asset funds are the product type of choice for these investors.”
According to data from the European Fund and Asset Management Association, demand for multi-asset funds, despite a reduction in demand for 2020, compared to 2019, is gaining further traction in 2021, with net inflows of €10 billion recorded in February 2021, up from €4 billion in January 2021.
A rising interest rate environment often heralds a strong economy and an uptick in inflation, which should benefit cyclical sectors including, for example, financials, energy and industrials. This type of environment is rich with opportunities for an active multi-asset manager, as opposed to passive buy and hold strategies.
A lot of investors are also concerned about a scenario pairing hyperinflation and a depressed economy. In our view, runaway inflation would be the result of undisciplined monetary policy or a major supply shock. While we have witnessed sizable increase in debt levels in many major economies such as the US, fiscal spending going forward is likely to be more funded and hence less inflationary. The near-term supply constraints are likely to push up costs such as raw material prices, but we foresee the bottleneck to be transitory. That being said, we do see some of the structurally deflationary factors such as globalization start to weaken and expect inflation to return in the coming decade.
In any of these scenarios, an active multi-asset portfolio is likely the best place to be. A Multi Asset funds approach to risk can guide investors to where they should be - and in a higher inflation scenario, investments like gold, broad commodities, energy stocks, short duration assets and select emerging market equities, amongst others become credible opportunities.
An approach that adapts – so that you don’t have to
Serious hikers and enthusiasts choose footwear that can deliver comfort and traction on a wide variety of terrain. We believe that multi-asset portfolios can do similarly by employing an approach that actively manages allocation decisions, while managing the entire portfolio to a volatility target.
This is an approach that adapts the asset mix so that you don’t have to. The goal is similar: Competitive performance with minimized participation in distressed markets.
* By Andrew Harmstone, head of the global balanced risk control strategy at Morgan Stanley Investment Management
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