Once more the much derided simple 60:40 mix of global equities and bonds has delivered excellent absolute and risk-adjusted returns (annualised returns of 6.6% with a sharpe ratio of 0.97 over the 10 years to 31/12/20191). By contrast, more complex – and expensive – absolute return funds, be they hedge funds or their liquid alternative counterparts have lagged far behind (annualised returns of 1.1% with a sharpe ratio of 0.35 over the 10 years to 31/12/20192). True, 60:40 has been flattered by extraordinary tailwinds that have blown since Federal Reserve Board chief, the late Paul Volker – that epitome of the public servant – bravely raised rates aggressively to tame inflation. That was in the early 1980s and this secular market regime is approaching the end of its fourth decade.
But looking ahead, things could be a lot more challenging for conventional beta-based approaches. Bond yields for one have been crushed to exceptionally low levels by developed world central bankers’ attempts to ‘keep the (growth) show on the road’, despite stratospheric debt levels. While a transition to materially higher inflation might not be in the offing over the medium term, even so mathematically returns are set to be dismally low compared to the past. Equity valuations are also elevated – reducing longer run prospective returns. True there are more benign longer-run growth and productivity possibilities which might lead to more favourable return outcomes, but the opposite could easily be the case too. Asset allocators need to step away from the positive short-term momentum and consider how they should be hedging the latter.
What continues to be the case in our view is that the surest way of generating acceptable returns in the future will depend to a large degree on harvesting the available risk premia of different asset and sub asset classes. The idea that manager trading skill can do the necessary heavy lifting was always questionable and the evidence of the last decade is powerful. As things stand, we strongly believe that managers are going to have to be much more selective about which risk premia are attractive to own and which are not. The other critical ingredient is likely to be the ability to hold those core positions patiently over the medium term. Such approaches, in the right hands, should be capable of delivering the necessary outcomes with much greater certainty than either naïve beta or shorter-term trading-based ones.
So, what is the view through the risk premia lens now? Where are we finding the most compelling opportunities? Well, 2019’s rally has generally left risk premia very compressed again – particularly in developed market fixed income despite the backdrop remaining structurally supportive. Hard currency emerging market bonds such as those issued by Argentine, South African and Turkish borrowers remain attractive as do selective emerging market currencies. In equities, Asia stands out as well as selective other emerging markets, as do the United Kingdom and Japan. To make further progress, financial assets require the liquidity and inflation environment to remain supportive and for the tentative bottom in industrial activity to evolve into a more positive growth environment – an outcome to which we currently attach the highest probability. But when those drivers fade, and fade they shall, there is a material risk of broad-based de-ratings. This, above all, argues the case for continuing selectivity and for retaining sufficient structural diversification in portfolios to preserve strategic ‘ammunition’ for the eventual longer-term opportunity. But that could be a story for 2021.