Andrew Hardy, CFA, Director of Investment Management Momentum Global Investment Management examines the factors driving recent performance of multi-asset portfolios and why he believes the funds offer the best risk-return opportunities in years.
Over the last 18 months, the performance of multi-asset funds has been disappointing; the usual benefits of diversification have been notably absent. Post 2008, ultra-loose monetary policy, near-zero and even negative central bank policy rates, and massive liquidity injections via Quantitative Easing, drove government bond yields down to levels never seen, close to or below zero.
Within this environment, bonds could offer neither the income nor capital protection necessary to make them constructive portfolio diversifiers. The risk in such highly valued securities was amply illustrated in 2022, when government bonds performed disastrously as central banks began the process of policy normalisation. US Treasuries returned -12%, UK gilts -25% and global government bonds -17%, extraordinarily poor returns for the world’s ‘safest assets’, providing no protection for investors at a tough time in markets.
The search for income from traditionally defensive sectors such as property and infrastructure to compensate for extremely low cash and bond yields was hit by the sharp rise in the risk-free discount rate, leading to big rises in capital costs, widened discounts to Net Asset Values (NAVs) and weak share prices.
Similar factors hurt the listed private equity sector, hampered also by a closed Initial Private Offering market and limited exit opportunities, as well as worries about underlying valuations in a tough environment.
Within the equity component of portfolios, performance relative to benchmarks has been hampered by the long period of outperformance by growth stocks, despite their high valuations, undermining the usual benefits of diversification in terms of investment style and market capitalization. The same trend has been even more extreme over the past six to nine months, when performance of equity markets has been concentrated in just a handful of mega-cap US stocks, driven in large part by the unfolding Artificial Intelligence boom.
The top seven US stocks now account for almost one quarter of the market cap of the US, a concentration level which few if any active managers would accept. This has resulted in nearly all active managers underperforming benchmarks over this period.
The net result has been a lengthy period when diversification into defensive assets was counter-productive, failing to provide stability in stressed markets; alternative sources of income offering some inflation protection and capital growth were hit by a near perfect storm; and equity market performance has been the most concentrated in decades.
Much improved opportunities now available across various asset classes
It is difficult to imagine a more challenging set of factors for multi-asset funds. However, that does not mean the benefits of multi-asset investing are no longer relevant. We have been through an exceptional period in economies, markets and policymaking. But the future looks very different and offers tantalising opportunities and prospects.
Enter fixed income. The single most important factor is the dramatic rise in policy interest rates over the past year, from around zero in the US and UK to over 5% now. Bond yields have reacted accordingly, and safe-haven government bonds now offer yields not available since before the GFC: 2Y US Treasuries and UK gilts are yielding around 5% and longer dated bonds 4-4.5%.
This reinstates the asset class to a key component of multi-asset portfolios, offering attractive and guaranteed income with zero default risk. Government bonds can now provide their traditional role of secure income and capital protection, with some upside potential as policy rates reach their cyclical peaks and begin to fall – something in sight within the next 12 months.
Cash is similarly a valuable portfolio diversifier and risk management tool again. As recently as March 2022, 1-month Treasury bills yielded zero, a level they had offered for almost the whole period since the GFC. They yield 5.2% today, a real return adjusted for US inflation. While a valuable tool at these yields, it is important to emphasise that this should be considered only for shorter term risk management purposes; yields will not be at these levels for a long period, and it is necessary to use the opportunity to lock in some of the high returns available in longer duration assets.
Many alternative assets in fixed income, infrastructure, property, private equity and other specialist areas, are trading at historic wides to NAVs and underlying valuations. We might not yet have reached the peak of the policy tightening cycle, but we are a long way through it. In due course the cost of capital will begin to fall and the headwinds facing these diversifying asset classes, many of which offer protection against inflation risks and some capital growth potential, will ease. The valuation opportunity on offer today is increasingly compelling.
For the first time in years multi-asset funds provide investors with true diversification, blending high income producing risk-free assets with exceptional valuation opportunities across a very broad range of assets – almost certainly the broadest ever available to investors.
Diversification remains the surest means of constructing optimal portfolios for a full range of risk-return profiles; the major headwinds of the past several years which have materially reduced the diversification characteristics and undermined returns of multi-asset funds have abated, creating exceptional opportunities for medium to longer term investors.
