Rising volatility and yields. Toppy valuations. Global policy uncertainty. To handle these bumps in the road, investors need to build a better return path focused on strong up/down capture. Further, we see seven key themes affecting that path ahead.
The Point of More Return
In the twenty-plus months leading up to the presidential election, many US markets overall didn’t do much more than earn income and dividends. Following the election, stocks and Treasury yields surged. Looking ahead, it’s impossible to know how policy will take shape—and how effective it will be.
That’s why it’s vital to build a better, sustainable path toward long-term returns: a portfolio that can capture more of a market’s upside than its downside. That’s known as a strong up/down capture ratio. To do it right, investors need to invest across a cycle’s ups and downs—and clarify their goals and preferences. The common goal: to get the up/down capture ratio as high as possible. In our view, that’s accomplished with better beta, efficient structure and targeted alpha.
Better beta. Some markets and market factors have better up/down capture ratios than others—they have better beta, or market-based returns. Currency-hedged global bonds when compared with US bonds are a good example.
Efficient structure. Combining certain betas in a portfolio may create more efficient up/down capture, too. For example, a combination of 50% high-yield securities and 50% Treasuries has historically had more up capture than down capture versus either part by itself.
Targeted alpha. Outperformance through active management (called “alpha”) can further enhance up/down capture, but it’s important to pick your spots: secular alpha opportunities created by post-crisis market conditions, areas where there’s potential for an information advantage, and inefficient indices that are easier to beat. Emerging markets fit the bill on all three counts, implying meaningful alpha potential.
How do investors put these principles into practice today?
Seven Ways to Build a Better Path in 2017 and Beyond
1) Stay away from problem children. If there are better betas, it stands to reason that there must be worse betas (market risks or factors) that investors should steer clear of. They may offer opportunities at some points, but over time they have poor up/down capture versus broad markets. Examples of problem children in the bond world include US corporate bonds rated CCC or lower and high-yield bank loans.
2) Avoid the crowds. Over the past 10 years—and especially following the long equity bull market after the financial crisis—crowding has become a bigger problem. Investors have tended to pile into popular trades such as high-dividend stocks, and the rise of passive investing means broad exposure to them. Following the crowd passively means owning all the good—and not-so-good—parts of a market or segment. That means trouble in any part can cause broad selling—and it can be hard to get out when things go south and everyone is trying to exit.
3) Master liquidity. Liquidity has been a hot topic following the financial crisis—sometimes trading in a market dries up and it becomes harder to navigate. But this can also create opportunities for investors to get more compensation for investing in less liquid assets. We’ve seen some of the most pronounced opportunities in this area within fixed income. Understanding how to capture illiquidity premiums while defending against liquidity reductions is just as important for bond investors as navigating interest rates or credit markets—and maybe more important.
4) Be the last active manager standing. Active management has been challenged in the years following the beta trade, as alpha opportunities have faded amid low volatility and dispersion. As investments increasingly go passive, it’s more challenging for markets to be efficient and price securities appropriately. That creates opportunities. What should investors know when they search for alpha, and will it come from different places—and in different ways—than it has in the past?
5) Relook at reemerging markets. Broad equity-market performance has been strong for developed markets in recent years. Emerging markets, meanwhile, have faced headwinds. Money that had been flowing into emerging markets seeking higher interest rates than in the US started to reverse course, impacting emerging-market currencies, stocks and bonds. There are opportunities to be found, but active management will be increasingly important in uncovering them—and in understanding how developed-market policies will create winners and losers.
6) Embrace alternatives 2.0. Alternative investments are likely to rely more on alpha and less on beta than traditional stocks and bonds. Alternatives have performed well over the long run, but the beta trade turned things upside down: alpha became harder to get and beta ruled. In the coming years, with more volatility and greater dispersion in markets, portfolios that are good at exchanging alpha for beta should benefit with better up/down capture.
7) Capitalize on trends around the world. Macroeconomic changes and other global developments should shake up capital markets, affecting economies, industries and—ultimately—investors’ returns. One development affecting such change could be the rise of populism and what that means for government policy and many large nations. Another could be questions of growth and debt in China. A third could be the impact of technology and evolving energy production or lower global trade on the world’s economic system. But the changes—and implications—will be sweeping.
These are seven themes we see right now; more will come into focus over time. Uncertainty dominates the market, so investors should consider shifting their focus from the level of returns to the path of returns. And they should emphasize well-designed portfolios that can weather bouts of volatility.
The views expressed herein do not constitute research, investment advice or trade recommendations and do not necessarily represent the views of all AB portfolio-management teams.