The markets over the past year have presented a series of challenges that have undermined the effectiveness of asset allocation in the near term.
The principal benefits of portfolio asset allocation – broadening the opportunity to generate gains and to reduce risk through diversification – have been rendered much less effective for a couple of reasons.
First, the European debt crisis risks and the ongoing slow growth and debt deleveraging cycles in developed nations have meant the actions of central banks and governments have primarily shaped the performance of financial markets, overshadowing corporate earnings and economic results.
Moreover, many investable assets have been deemed ‘risky’ by the markets and have tended to become more correlated, significantly eroding the value of crafting asset allocation strategies in the first place. Given these adverse circumstances, many investors preoccupy themselves with a ‘flight to safety’ in an attempt to preserve their wealth.
The elusive search for ‘safe assets’
Market developments over the last year have fundamentally altered the market’s perception of the concept of a ‘safe haven’.
The budget stand-off and ratings downgrade in the US last year; central bank interventions impeding the Swiss franc; wholesale ratings downgrades of AAA and AA corporates and countries; and gold failing to perform in the midst of the type of market and political uncertainty for which investors hold the asset – all these developments have made it difficult to consider any asset to be a true ‘safe haven’.
Instead, the issue is one of relative safety, and from which risks.
In the now bygone era when safe haven investments could often be counted on to produce a return that might at least keep pace with inflation, the downside to being safe was simply the opportunity cost of generating higher returns.
However, in an environment where safe assets are defined solely as being expected to provide capital preservation, the risk of wealth erosion due to inflation and other factors (such as taxes and fees) should be a primary concern for private clients and their wealth managers.
Today, people seeking ‘safe’ status by investing directly in real estate in high-demand geographies are implicitly incurring concentration and illiquidity risks at the same time.
Investing in capital-protected notes linked to some underlying security or asset class shields the holder from the downside of the underlying investment, but concentrates the risk with the financial counterparty for the note. And investing in UK gilts, US Treasuries, German bunds or simply staying in cash results in the wealth erosion problems highlighted above.
In short, seeking ‘safety’ is like chasing shadows. Instead, the conversation that wealth managers should be having with their clients is how to better balance the trade-off of a series of risks (liquidity, concentration, counterparty, and wealth erosion due to inflation, taxes, and spending) in this ultra-low yield environment.
As an example, for some clients, owning a diversified, high quality, liquid portfolio of short-duration corporate, inflation-linked and government bonds might be a better overall solution than trying to find a single ‘safe’ holy grail.
Defining risk and seizing opportunities
Despite ongoing uncertainty, attractive investment opportunities do exist.
For example, although investors are concerned about both the market and the health of the global economy, the most widely followed ‘risk and anxiety’ measure – the US Vix – is actually still at relatively low levels. Investment strategies taking advantage of this low volatility despite heightened investor concerns are therefore worth investigating.
That said, these types of opportunities may not be appropriate for every investor to exploit. Risk requires a personal definition to capture how much can be tolerated and how liquid a position they need to maintain.
A common mistake made by investors and market commentators alike is to place too much emphasis on the near term. The time horizon of most investors is often not as short as they may think, even if the focus of their anxiety is on the immediate period.
If investors are able to focus beyond the immediate future and recalibrate their expectations to what they need over time – whether it is to provide for a certain lifestyle in retirement, for a first house or to fund their children’s future educational needs – then a broader range of attractive investment opportunities may open up to them.
George King is managing director & head of portfolio strategy at RBC Wealth Management