Diversification, Selectivity & Dynamism Are Needed to Tackel Market Challenges by Yoram Lustig

We are experiencing extraordinary times in financial markets says Yoram Lustig, author of The Investment Assets Handbook

I have no doubt that investors always think the times they are living through are astonishing. But just examine what financial markets are telling us today and you will agree that these conditions are as unusual as they are remarkable. While such markets might make life difficult for investors, they also present great opportunities and my approach is to concentrate on diversification, selectivity and dynamism to get the best results.

The 2008 global financial crisis shocked financial markets, taking them to the brink of a meltdown. But it is the market dynamics following the great recession that have led us to the current situation, packed with record-breaking extremes.
Following the crisis central banks across the globe, in the US, UK, Japan and Europe, launched unprecedented measures of unconventional monetary policies in the form of quantitative easing (QE). The task was nothing less than saving the financial system by reflating fragile economies and pulling them out of a deep recession.

Easing

QE involved buying government bonds and pushing their yields to record lows. And flushing markets with liquidity also helped push some equity markets to new all-time highs. Figure 1 correlates the US 10-year Treasury yield with the performance of the S&P going all the way back to 1926.

As policymakers aggressively cut short-term rates, sometimes into negative territory, the new environment pushed some real estate markets upwards, reaching bubble conditions. Whether QE was the cure or another disease is yet to be seen, but undoubtedly it created financial extremes.

Figure 1: Dropping US 10-year Treasury yields and rising US equities [REMOVED]
Source: Bloomberg, January 1926 to December 2014

Changing World

However, it is not solely QE that brought with it the extraordinary conditions we are facing today. The world is a dynamic place that keeps on changing. China, once the global growth engine, began its secular decline towards what some would call a ?normal economic growth rate?. The oversupply of petroleum, together with falling demand, as well as some conspiracy theories of Saudi Arabia against the US fracking industry and US against Russia and Iran, pushed oil price off a cliff to a 50% free fall. The dropping oil price has taken inflation down with it, towards deflationary territory. The desire to export deflation, reflate economies and enhance competitiveness of exporters has meant a series of global currency wars, seeing the US dollar appreciating and some other currencies collapsing.

After decades of increasing globalisation, the world?s economies are entangled. What happens in Europe affects the economic fortunes of China and Japan. Their fortunes impact those of the US. And the mighty economy of the US, with its colossal consumer base, affects what happens in the rest of the world. When the US consumer sneezes the rest of the world catches a cold. This integration locks together the global economy, losing some of the risk-mitigation properties of global diversification.

In a world of extremes and uncertainty about economic growth, changing sentiment and news can cause large shifts in asset prices, injecting volatility into the system. When inflation expectations are so low, any shift in perception, due to a rise in oil price or upbeat forecasts of economic growth, can lead to a swift hike in bond yields. When equity prices are touching the sky, any disappointment relative to expectations can lead to a swift correction. And when the global economy relies on experimental QE, any rhetorical glitch by policymakers or political instability can lead to swift movements in asset prices.

Volatility is likely to intensify in this environment.

Volatility

This is not the only factor amplifying volatility. The proliferation of hedge funds and speculators with derivatives at their disposal allow them to trade notional amounts in the billions. Traders can accelerate trends in the markets, causing asset prices to disconnect from fundamentals.

Logically, high asset prices today translate into low future returns. These challenging low expected returns are likely to be accompanied by a volatile regime. The end of QE in the US, political difficulties in Europe, Japan struggling to exit its prolonged recession and slowing down in China are likely to further increase uncertainties. Uncertain oil prices, an increasingly complex geopolitical backdrop and a transformational, integrated world, just add more fuel to the fire.

The result: We are living in a volatile world of extremes. High equity prices mean lower future returns. Low bond yields mean lower future returns and the limited protective power of fixed income in multi-asset portfolios. Low rates and low inflation mean cash and conservative assets deliver meagre returns, pushing investors to riskier instruments, only to further inflate bubbles.
This is a challenging global financial market. And we, the investment professionals, need to deliver risk-adjusted returns in line with the expectations of our investors. There are no excuses, as we are going to be measured by the outcomes we deliver.

The solution

So what should investors do to venture through this uncharted territory? The answer is Diversification, Selectivity and Dynamism.

Diversification. One of the oldest tricks in the investment book to reduce risk is diversification. In a world of low returns, high risks and correlated markets diversification needs to be broad across global assets. Global multi-asset investing is the way to achieve proper diversification.

Diversification needs to be active, not passive. Gone are the days that investors just had to buy a bunch of stocks and a bunch of bonds and hold them to satisfy the need to diversify. This strategy could have worked in the 1980s and 1990s when equity markets kept rising and bond yields kept falling over the long term. The two major asset classes in portfolios, equities and bonds, enjoyed a secular bull market.

But these days, when markets are volatile and expensive, investors need to maintain diversification on an ongoing basis by constantly seeking uncorrelated assets and diversifying not only across and within assets but also across risk factors that drive the returns and risks of assets.

Selectivity. Identifying and selecting assets within a broad investment opportunity set, and precisely expressing market views, can distinguish between opportunities and risks. For example, separating oil exporting and oil importing emerging markets and selecting those that can benefit from the drop in oil price demonstrates what selectivity means. Treating global emerging markets as a single block is a mistake.

Volatility brings risks, but also opportunities. Diverging monetary policies, economic growth rates and inflation cause assets to perform differently. This environment is ideal for skilled selectivity to outperform the general market.
Investors need to embrace volatility and not fear it. The real risk of long-term investing is permanent loss, not volatility per se. Volatility should bring a reward for accepting the risk and it should bring opportunities for selective investors as asset prices diverge.

Dynamism. When the expected returns from each asset class are low, a dynamic approach seeks opportunities across assets and everywhere. Tactical asset allocation can add invaluable growth and mitigate risks. The key is multi-asset investing with the skill and common sense to do it well.

When the returns in one asset class, region or sector are expected to be low or risk is expected to be high, investors should shift their focus elsewhere to harvest more attractive returns. In my view, there is no room for rigid asset allocation anymore and those who are nimble will prevail.

Yes, financial markets are going to be challenging. And yes, volatility is going to be high. But in these market conditions those who are diversified, selective and dynamic can differentiate themselves. Extraordinary times mean extra is needed to stand above the ordinary.

Only by understanding the markets, always looking out for what can go horribly wrong, can investors apply the judgment needed in these uncertain times. In uncharted territory it was the likes of Marco Polo, Columbus, and Magellan who dared and succeeded. This time is not different, but we have not been here before.