How can investors future-proof their portfolios?

The past decade has been the era of the great monetary policy experiment, with long-term quantitative easing across the US, UK, Europe and Japan. But as that epoch draws to a close, investors need to find new ways to ensure continued returns from their portfolios in a volatile world of rapidly changing economic and market environments.

Most fund managers agree that one of the big legacies of the years of low interest rates has been encouraging investors worldwide to take greater risks in order to achieve returns for their clients.

‘Whether we like it or not, the policy of quantitative easing has pushed investors further up the risk curve,’ says Darren Ruane, head of fixed interest at Investec Wealth & Investment. ‘Ten years ago, investors would be used to getting 5% or 6% returns from the bond market without taking huge amounts of risk, and they were happy with that. In today’s world, that’s not possible.’

Balancing choices

With continued political and economic uncertainty ahead, investors remain unsure whether a recession is waiting around the corner or if the dovishness of the Federal Reserve will prolong the economic cycle. With this in mind, a balanced portfolio that covers all possible outcomes is more important than ever.

‘You have to look at how you can protect portfolios in case interest rates and inflation go up, as they did in the US over the past three years until January and February of this year,’ Ruane says. ‘So, for example, from a bond perspective, if rates and inflation are rising, you can buy bonds that have a floating rate coupon, so you get that benefit in a more inflationary world. But you also have to have things in your portfolio to protect you in case economic growth is not as good as people predict.’

In a world of low interest rates with little inflation, a common strategy is to dedicate a portion of the portfolio to government bonds. While these have historically been unattractive, they can often be relied upon to yield more attractive returns than other asset classes if rates turn out to be lower than expected. But one of the key strategic innovations that some wealth managers have been employing is investing in private debt markets. While this involves a higher level of credit risk, it does offer a means of eking out far higher returns due to sizable illiquidity premiums.

‘We’ve been doing this for six or seven years now,’ Ruane says. ‘We invest in infrastructure funds, those which focus on both social infrastructure – which tends to be government-backed vehicles – and then commercial infrastructure such as transport or airports. A portfolio of these infrastructure assets can generate returns close to 9%.’

Is technology the answer?

Other investors aim to capitalize on global trends, such as the ongoing trade war between the US and China, to identify new sources of return. At Myria Asset Management, fund selectors follow a top-down approach to define and identify growth in different geographical areas and sources of risk in others.

‘Right now, we think US equities are fundamental to our portfolio, because growth is a function of population and technology, and right now technology is fully taking off within the US,’ says Myria director general Pierre Bismuth. ‘But because of the trade war and its impact on Chinese equities, we’re also really underweighting emerging markets for now. We’re also investing in emerging market debt as a satellite part of the portfolio, but mainly in investment grade countries that are more economically sound than, say, Venezuela or Argentina.’

The increased digitalization of markets such as retail and even real estate also provides investors with a whole new cast of potential winners and losers. However, when it comes to future-proofing portfolios, managers have to decide whether to have a full weighting in technology companies or to underweight the industry because they perceive it to be too expensive.

‘There are two ways you can look at it,’ Ruane says. ‘Some people feel that IT is the beating heart of the equity market in countries such as the US, and they’re happy to invest in the index through things like ETFs in order to capture that. But there are also long-term losers in these sectors as well, as other people think that some of these companies, such as Tesla, are overpriced because they’ve never made a profit.’

Some investors turn to third-party fund managers who try to utilize Big Data and artificial intelligence to gain an edge in spotting long-term winners. However, others point out that these strategies are still at a relatively early stage in their development, and there is sometimes little proof that these concepts work in the real world.

‘We have some managers in our portfolios who are applying artificial intelligence to Big Data, but we tend to be conservative, and we only use managers who can show that their approach to Big Data can deliver returns,’ says Juan Hernando, head of fund selection at Morabanc.
This year’s falling interest rates have increased the appetite for taking risks. At the same time, many investors are keenly aware that their future strategic outlook depends heavily on how long the current economic cycle lasts.

‘Returns across the board, from equities to bonds, are very strong this year, because rates have fallen again,’ Ruane says.

‘The latest thinking is that more monetary easing is going to be required, because the health of the global economy is not as good as people thought it was last year. With rates falling again, it might extend the time until the next recession.

‘But the big thing investors are trying to calculate is just how long it will be before the end of the economic cycle, and how we prepare our portfolios for that.’