Capital Allocation in Current Markets
We believe that investors need to evaluate whether the perceived investment risks inherent in their asset allocations can be compensated for given the anticipated market environment. Of the risks typically faced by most investors, we focus on those that are most likely to adversely affect investors’ portfolios if left unaddressed.We approach this from the perspective that some investors seek to achieve a combination of sustainable income, long-term capital growth and/or capital preservation.
Strategy Implication: Nominal Interest Rate Duration
While it may still be too early to call the end of the three-decade bull market in interest rates, and while rates have fallen back somewhat in March, the balance of risks has clearly and meaningfully shifted to the upside. This is a risk that directly and indirectly permeates many elements of an investor’s portfolio through exposure to fixed income and other interest rate-sensitive asset classes. Unaddressed, rising interest rates can jeopardize both the income-seeking and capital-preservation goals of investors.
Possible Actions to Help Mitigate Interest Rate Risk
Include the reallocation of capital towards unconstrained multi-sector fixed income products, greater global fixed income market exposure, increased holdings of floating rate corporate debt/private debt, corporate credit, investment in laddered bond structures and other “hold-to-maturity” strategies.
Strategy Implication: Rising Inflation Expectations
Inflation is a silent killer. For investors whose portfolios are comprised predominantly of financial assets backed by nominal cash flows, such as coupons and dividends, inflation can erode the purchasing power of these cash flows and therefore impair the value of the financial asset supporting the cash flows. Inflation risk for now remains nascent; however, investors should consider allocating a greater share of their capital to assets with embedded inflation protection as we expect upside inflation risks to increase going forward.
Possible Actions to Help Mitigate Inflation Risk
Include greater exposure to real assets such as commodities and commodity-linked equities, Treasury Inflation-Protected Securities (TIPS), real estate and infrastructure. This can be achieved either through individual asset class exposure or via blended multi-strategy approaches.
Strategy Implication: Assumed Correlations
Proverbially referred to as the only ‘free lunch’ in investing, diversification, as an investment risk management tool, depends on its effectiveness on the degree of correlation between the asset classes and strategies that comprise investor portfolios. Typically, the greater the level of correlation across a portfolio, the lower the overall level of diversification. In and of itself, low or high levels of portfolio diversification represent neither desirable nor undesirable outcomes, as the context of the overall investment objective of the portfolio needs to be considered when making this assessment. For example, forgoing diversification in favor of certainty of income for an income-seeking investor may be an optimal trade-off.
Nonetheless, what remains paramount regardless of the investment objective is that, where diversification benefits are sought, understanding and managing the inherent variability in correlations is vital from a risk management perspective since diversification cannot assure a profit or protect against loss. The evolving policy environment has the potential to destabilize correlations both within and across asset classes relative to the recent investment environment. Incorporating this emerging risk into the design of a portfolio is an important consideration today.
Possible Actions to Help Mitigate Correlation Risk
Consider embracing a more dynamic approach to asset allocation to anticipate and manage the impact of unstable asset class correlations and volatilities. Investors should also exploit asset classes and strategies that have a structurally lower correlation relative to that of the incumbent asset in their portfolio in order to lower expected volatility without compromising on target income or return potential. Strategies can include certain alternatives and multi-factor-based investments that adopt different weighting schemes to help mitigate the dominance of equity risk in an overall portfolio risk.
Strategy Implication: Uncompensated Market Risks
At a time of heightened policy uncertainty, with the possibility that left tail risks† dominate market sentiment, and with elevated market valuations for certain equity and credit markets, the preconditions for a correction in risk assets are firmly in place. This is not a forecast but simply a statement acknowledging the existence of risks that could adversely affect income-generating, capital growth and/or capital preservation goals. Investors tethered to these risks via their allocation to either passive strategies or active strategies which are closely managed relative to passive indices should consider adopting a more unconstrained active approach that seeks to avoid some of the drawdown risk implied by current market conditions.
Possible Actions to Help Mitigate Market Risk
Consider allocating to unconstrained active equity and fixed income strategies whose risk profiles can diverge significantly from their representative benchmarks. This approach allows for the possibility of limiting market-derived tail risk without necessarily giving up expected returns.
Strategy Implication: Active Risk vs. Market Risk
The factors influencing the case for becoming more vigilant with regard to uncompensated market risks are also signaling the potential for a period of strong performance for active management. Currently, there is an emergence of conditions that we believe are necessary (but not sufficient) for active management success. After a prolonged period of elevated correlations and lower relative risks within and across asset classes, equity markets and sectors, correlations are falling and security-specific volatility is rising.
In general, the benefit from active management requires securities, relative to each other, and relative to the indices they comprise, to diverge in performance. Analysis suggests this is beginning to happen. In a world where expected returns for market risk are subdued, we believe active returns should be more explicitly emphasized as a driver of capital growth and income generation for investors. From an overall risk budget perspective, we see market risk crowding out active risk as the leading factor explaining returns.
Possible Actions to Help Address Active Risk
Allocate a greater share of capital to various types of active risk approaches that focus on absolute return generation from across both traditional and alternative asset classes.
Connecting the Dots: From Investment Strategy Implications to Product Strategies
We offer a range of strategies that we believe can help clients meet investment challenges while simultaneously addressing more than one uncompensated risk. This chart summarizes some of the strategies that may act as a possible resolution to the five prominent uncompensated risk challenges we have outlined. For more information about these Dreyfus strategies, view our funds.