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Asset Allocation Letter - Low volatility does not mean lack of risk

EDITORIAL

 

Since the beginning of the year the resilience of global equity markets has been impressive. Year-to-date the MSCI AC world is up c.11% and developed stocks by 10.5%. Despite some headwinds, such as weak Q1 US economic growth, drop in commodities and energy prices, a lack of positive news flow related to the Trump’s tax reform, investors have been surprised by the strength of the global equity market. Many attribute such a strength to the recovery in earnings growth, others to the recovery in emerging markets economic growth which has reduced the risk of recession. We believe that stocks have been mainly supported by two factors. First, the recovery in profits in the euro area and in emerging markets. Second, the low level of bond yields which increases the current value of future cash flows. Indeed, although stock prices have generally trended up, equity risk premia (calculated by the Dividend Discount Model) are still attractive across the world as bond yields remain low in an environment of positive growth. Low bond yields have also played another important role in driving investors’ assets outside developed fixed income markets into low volatility and dividend stocks which offer generous and relatively safe dividend yields. 

Abundant liquidity and easy financial conditions (dollar depreciation and tightening spreads) have driven stocks further up and pushed implied and realized volatility down. Along with stocks-related fundamental reasons, equity markets have been supported by other factors: easy financial conditions and abundant liquidity. These factors have also been two important catalysts for the low volatility levels observed across various markets, especially equity ones.

 

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Low equity volatility means that markets daily moves have been gentle not that risk has diminished. Low volatility means that markets daily moves have been gentle rather than volatility has diminished. The chart below clearly shows that when volatility reaches such a low levels, a reversal trend is getting more likely. We are not arguing that an equity sell-off is imminent but rather that the current environment is well discounted and that a small change in the central scenario may bring volatility up again (earlier elections in Italy, slowing growth in China in the H2, delay in Trump’s fiscal stimulus). We do not expect a major sell-off as dispersion is still high and especially across US stocks (i.e. US value stocks have underperformed the MSCI US by more than 11% since the beginning of the year, while US tech stocks have outperformed by more than 11%). Big market sell-offs usually occur when volatility is low and correlation high. However we believe that, for most of the developed equity markets, fair values have been reached and that the risk/reward profile has recently deteriorated.

 

What do to in a Multi-Asset fund? As complacency seems higher, we keep a moderate stance in terms of risk budget across our funds. We now favor relative value strategies over directional ones, we avoid expensive asset classes (we are underweight US growth stocks and very selective in our credit picking). We have reduced the exposure to carry strategies which are usually a proxy of a short volatility approach.

 

 

 

Claudia Panseri

Multi-Asset Portfolio Manager

 

 

CONVICTIONS

Investment scenarios

  • Our central scenario, based on a limited but stabilized global growth remains valid - around 3.2% per year in 2016-2017 – with a 70% probability of occurrence (stable). US growth should be slightly higher than expected for 2018 (2.0% vs 1.7%) and Developed Economies globally driven by domestic demand (Europe, US, Japan). Emerging Markets should improve benefiting from the stabilization of oil prices. This environment should favor risky assets and also QE friendly assets (Euro Corporate and Equities, Peripheral Sovereign Debt). 
  • Our first alternative scenario(decrease at 15% probability) assumes an acceleration of US growth as well as US inflation expectations thanks to fiscal expansion leading markets to reprice rates higher and USD stronger, with the Fed eventually more aggressive than initially anticipated. It would create a widening gap between disappointing growth expectations and sustained inflation expectations.
  • Our second alternative scenario sees a global growth slowdown with 15% probability of occurrence (increase). The trigger could be a deterioration of the US economy (Trump downside), tighter policies in China or the consequences of the Brexit vote. 

Positioning under our central scenario

The intermediate risk budget is stable at 6 out of 10.

  • On equity markets, we remain moderately long versus benchmark

-    Geographically, we maintain our preference for Eurozone equities (the region remains supported by upwards earnings revisions, relatively attractive valuations and lower political risk). We also keep our overweight on Japan as valuation is attractive and earnings momentum very strong. We  maintain our underweight on US as valuations are at all-time highs and earnings are losing steam. On Emerging Markets, we keep a neutral stance as there are still question marks related to USD level, US interest rate hikes and risk on US tariff policy. However EM equities are cheap and earnings recovery underway. We keep the underweight on Europe ex-EMU as valuations are extremely expensive especially in Switzerland and UK.

-    Sectors/factors: we still favor a Value bias in Eurozone and rebalance our exposure between “Quality” and “Value” in the US by decreasing our positions on “Value” stocks.         

  • In the fixed income space, we keep an underweight exposure in nominal duration and a long exposure to higher yielding FI assets (except US High Yield)

-    Rates: we maintain a short duration exposure to Core Eurozone and a moderate long exposure to Peripherals. We keep a slightly long US duration (just as macro hedging). 

-    Credit: we are still globally positive on the asset class. The overweight exposure is still balanced between Industrials and Financials. We still have long positions on Euro High Yield and we could potentially arbitrate to favor EM debt in local currency. We reduce our exposure on US High Yield (fair value and oil price sensitivity).

  • Currencies: we maintain a long position on JPY but we do not implement other significant exposure on Forex.
  • Macro Hedging: we maintain the hedging positions against European risk, especially on equity volatility. We maintain a moderate long exposure to US Treasury and Japanese Yen.

Cross asset views and portfolio positioning

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FOCUS

How to structure the Equity portion of an institutional asset allocation?

One of the questions most frequently asked by institutional investors is how to structure their asset allocation. The traditional model of segmentation between major asset classes – mainly equities, fixed income and diversification assets – leaves room for, or combines with, other approaches, based on end objective, macroeconomic factors (growth, inflation indexing or stress hedging) or level of liquidity, depending on the investor’s constraints. These questions are also raised with regard to the equity allocation of their portfolios, which can be structured geographically, by sector, or by factor. This article details our recommendations in this area, based on our experience in our asset allocation advisory business and the development of allocation solutions for institutional investors.

When investors buy equities they aim to capture:

  • The equity risk premium, a source of long-term performance, within a beta portfolio typically invested in passive investment strategies or strategies with a low tracking-error;
  • Other risk premiums that have proven to pay off over the long term. The value and size factors are the most often mentioned in the financial literature; to this list we can add quality, which has been recognised as a factor in recent articles and integrated as such in some of our investment processes; there is also momentum and low volatility, which we would consider, rather, as market anomalies1. The factor portfolio, which seeks to capture these premiums and limit the now well-known biases of market cap-weighted indices, may be constructed:

-    statically, for example via an equally risk-weighted combination between exposure to the size, quality, momentum and low volatility factors;

-    or dynamically, to tap into the differences in behaviour of these factors, based on the position in the economic cycle2.

Alpha, which can be found in:
-    some managers’ proven ability to add value through a strong security selection skill. Studies have shown here that alpha generation is easier on less efficient markets, for example, emerging or Japanese markets, than on highly efficient markets, such as North American large caps. This explains why investors prefer a passive approach to the latter. To identify such managers, we have to make a clear distinction between actual alpha and systematic exposure to certain factors; the reason for this is that many successful stock pickers are managers whose portfolios are structurally biased towards small caps or value stocks; so selecting managers requires a fine understanding of historical sources of returns.

-    A tactical allocation between countries, factors or investment styles. This allocation can be:

implemented by the investor himself/herself;

in the form of a selection of global equity funds managed actively based on a top-down approach, with extensive tracking-error to have an impact on the allocation’s performance;

be delegated to one or more allocation managers via overlay mandates; to work properly this option requires transparency on the various components of the investor’s portfolio.

  • And, lastly, an illiquidity premium, accessible to investors who are not subject to liability constraints (e.g., sovereign-wealth funds and university endowments). So we feel it makes more sense to include private equity investments in a growth portfolio, rather than in an illiquid portfolio of investments containing assets with very different economic objectives (real estate and private debt, in particular).

The next question to address is on allocation between these four sub-portfolios, which, for simplicity’s sake we will call beta, smart beta, alpha and Illiquidity. The answer depends on many parameters, such as:

  • The investor’s philosophy, in terms of priority given to active or passive investment management or his/her belief in the efficiency of markets and the importance of different sources of performance. The size of the investor’s portfolio: in the case of sovereign-wealth funds managing several hundreds of billions of dollars, the weighting that can be allocated to smart beta or illiquid strategies could be restricted by the size of the target market. Conversely, if his/her portfolio is too small, it will be hard for the investor to access the top-performing private equity funds or alpha managers at reasonable cost.
  • His/her resources, in particular in terms of selecting vehicles and monitoring the risks and performances of funds used. In this case a less complex approach is more adapted, or greater delegation of portfolio construction to global managers.
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By way of illustration, and focusing at this stage on the liquid investments of the Growth allocation, we recommend:

  • a core allocation amounting to 60 to 70% of the portfolio, split between, on the one hand, pure beta strategies (30 to 40% of the portfolio), for example in ETFs, in order to facilitate active  management of the portfolio allocation, and, on the other hand, smart beta strategies (20 to 30% of the portfolio). 
  • a satellite allocation amounting to 30 to 40% of the portfolio, split, here again, between top-down management with a high degree of tracking error (10 to 20% of the portfolio) and a bottom-up strategy invested in stock-picking vehicles (10 to 20% of the portfolio), particularly on emerging and Japanese equities.

Regarding implementation, the choice between dedicated mandates and open-ended funds will depend on the amount of assets invested and the institution’s constraints in terms of reporting and resources that can be devoted to adjusting and monitoring investments. 

To limit long-term non-financial risks, an ESG filter can be used to select stocks in the portfolio, based on a process ensuring low tracking-error against standard benchmarks. Likewise, investors aware of the structural risks incurred from climate change may, in addition to measuring their portfolios’ carbon footprint, set up a filter excluding the heaviest polluters and/or invest opportunistically in sustainable assets. 

Diversifying sources of performance, structuring equity portfolios between beta, smart beta, alpha and illiquidity, and integrating climate risk should therefore serve as keys to structuring an equity portfolio.

 

[1] T. Roncalli, “Alternative Risk Premia: What Do We Know?”, Amundi Working Paper, April 2017

[2] See also A. Russo, “Equity Factor Investing according to the Macroeconomic Environment”, Amundi Discussion Paper, November 2015

 

Eric Tazé-Bernard

  Chief Allocation Advisor

 

PERFORMANCES

Gross performances of our strategies (May 31st, 2017)

Amundi, data as at end of May 2017. Gross performance of “Balanced Institutional Absolute Return Low volatility “, Multimanager Multi-Asset Fund of Funds (Bonds)“ GIPS composites in euro. Their respective benchmarks are: Eonia capitalized and a composite benchmark: 50% JPM EMU Government Bond Index, 30% JPM Government Bond, 20% Exane ECI – Europe Convertible. Past performance is not a reliable indicator of future results or a guarantee of future returns. 

 

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TIGNARD Laurent , Global Head of Multi-Asset, Institutional Clients
PASCAL Frédéric , Deputy Head of Multi-Asset, Institutional Clients
TAZE-BERNARD Eric , Chief Allocation Advisor
BEN ABDALLAH Marc-Ali , Senior Analyst, Investment Solutions
NETO Florian , Client Portfolio Manager
LEVY Dan , Head of Multi-Asset Investment Specialists
DEBOUT Leslie , Investment Specialist
HEISSAT Jean-Thomas , Investment Specialist

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