Strategies for periods of low risk premiums

13/04/2018

Summary

The prolonged low-interest-rate environment is forcing institutional investors to come up with new strategies to reach their target returns. One way they can do so is by broadening their traditional portfolio allocations to include alternative investments offering higher riskadjusted returns, better diversification, and lower market sensitivity. However, this does involve some specific challenges.

LOW-INTEREST-RATE ENVIRONMENT

This year, the challenges facing institutional investors in achieving their target returns remain as great as ever. In a low-interest-rate environment which has now lasted more than 100 months, the task of dealing with diminishing risk premiums has led to many innovative solutions, but these reach their limits more and more quickly. Many decision-makers are not short of ideas or innovative talent, but they are often prevented from realigning their investment strategies – toward alternative investments, for example – by investment guidelines which no longer meet their requirements.

The need for alternative sources of return will continue to grow, for the following reasons1:

1/Financial repression is not only continuing – it has actually reached a new level in the last few years. Yields on government bonds with high credit ratings are still in negative territory. Hence they no longer fulfil their traditional role as an income-generating investment. The normalisation of monetary policy expected in the coming years must be priced in, and implies further downside risks. Furthermore, government bonds will probably cease to show a strong negative correlation with risk-bearing asset classes.

2/The bullish trend of equity markets will continue to be driven by a continuing loose monetary policy, and a world economy expanding broadly in line with its potential rate. But how much upside potential do equities really have?

3/It is gradually becoming necessary to prepare for increased volatility. High valuations, possible normalisation of monetary policy by relevant central banks, and heightened geopolitical risks could soon lead to a correction for risk assets.

In this scenario, our advice is to look for alternative investment strategies with a conservative risk-return profile as a substitute for bonds, supplement the equity allocation with market-neutral strategies with low effective exposure (beta), manage volatility, and implement hedging strategies. Extending a traditional portfolio allocation to include alternative investments allows investors to achieve a higher risk-adjusted return, better diversification and potentially lower market sensitivity.2

This is often easier said than done. In this article, I would like to focus on the use of liquid alternative strategies.

"IN A LOW-INTEREST-RATE ENVIRONMENT WHICH HAS NOW LASTED MORE THAN 100 MONTHS, THE TASK OF DEALING WITH DIMINISHING RISK PREMIUMS HAS LED TO MANY INNOVATIVE SOLUTIONS, BUT THESE REACH THEIR LIMITS MORE AND MORE QUICKLY."

LIQUID ALTERNATIVE INVESTMENT STRATEGIES

Now that there is such a wide range to choose from, it is wise to invest in a diversified portfolio made up of different alternative strategies. In practice, this diversified portfolio often has two objectives: a) to generate positive income over a market cycle with low risk, and b) to make a valuable contribution to the overall portfolio by enhancing returns and diversification.

Depending on the risk budget, based on our inhouse estimates, we believe a bandwidth of 1.5% to 3.5% above EONIA to be a realistic target. Starting with a typical institutional equity-bond portfolio, and allocating 10% to a basket of liquid alternative investments instead of bonds, can increase portfolio return expectations by 0.1 to 0.3 percentage points (depending on the structure of the absolute return portfolio) over the medium term.1

SYSTEMATIC INVESTMENT PROCESS

The following investment philosophy has been proven to achieve this goal:

  • Collect different alternative risk premiums
  • Focus on risk management
  • Aim for broad market neutrality vis-à-vis equity and interest rate risks

Implementing this investment philosophy calls for a systematic approach2:

1/ STRATEGY DEFINITION:
First, the investor should state his expectations as to the desired risk-return profile realistically, and define the permitted strategy spectrum, taking any restrictions into account.

2/ MANAGER SELECTION:
The investor should identify managers who model the alternative risk premiums effectively and in a stable manner over time. These managers should differ with regard to their strategy spectrum. Qualitative analysis is particularly important when selecting alternative strategies.

3/ PORTFOLIO CONSTRUCTION:
When creating an absolute return portfolio, in addition to the primary aim of generating returns while reducing overall risk, attention must also be paid to avoiding cluster risks. Quantitative tools such as forward-looking modelling, optimisation and risk breakdown should be supplemented by qualitative considerations such as predetermined, built-in constraints to optimisation and scenario analysis.

4/ MONITORING:
Ongoing quantitative and qualitative monitoring at investment level is important, in order to compare performance with the expected riskreturn profile of each strategy, to evaluate any performance outliers, and to make any necessary changes to the portfolio in good time.

A: LIQUID ALTERNATIVE (ABSOLUTE RETURN) STRATEGY SEGMENTS

LIQUID ALTERNATIVE (ABSOLUTE RETURN) STRATEGY SEGMENTS

Source: AllianzGI Global Solutions.

RISK PREMIUMS AND PERFORMANCE CHARACTERISTICS

To benefit from the whole range of alternative strategies, investors need to be aware of the different types, specific risk premiums and performance characteristics of these strategies.

Strategies in the “relative value” and “event-driven” segments often specialise in isolating alternative risk premiums (e.g. volatility, merger arbitrage). Directional market exposure (vis-à-vis equities or bonds) is not typically a main driver of returns for these strategies. “Macro strategies”, by contrast, involve deliberate and dynamic exposure to directional market influences. They seek to profit from short and long-term trends or macroeconomic developments. “Equity long/ short” strategies, on the other hand, are strongly driven by stock selection with corresponding equity market positions, but also seek directional exposure.

Our company’s analysis clearly shows that the equity market-neutral, merger arbitrage and credit long/short segments have the effect of reducing risk in a portfolio context, while the global macro and managed futures segments can perform the role of generating returns.1

B: IMPLEMENTATION PROCESS FOR A LIQUID ALTERNATIVE STRATEGIES PORTFOLIO

PROZESS FÜR DIE UMSETZUNG EINES PORTFOLIOS VON LIQUIDEN ALTERNATIVEN STRATEGIEN 

Source: AllianzGI Global Solutions.

CONCLUSION

Investors can achieve attractive risk-adjusted returns at low risk with a diversified portfolio of liquid alternative strategies, thereby enhancing returns and diversification in the overall portfolio.

Given the heterogeneous nature of the strategies on offer, an in-depth understanding of alternative risk premiums and intelligent portfolio construction are important to achieving the desired results. An investment process in which the strategy definition, manager selection, portfolio construction and monitoring are specifically tailored to liquid alternative strategies will also be advantageous.





Adrian Jones Dr. Wolfgang Mader,
Head of Investment & Risk Strategy,
risklab
Adrian Jones Arne Tölsner,
Head of Institutional D/A/CH,
Allianz Global Investors

 




1) The statements contained herein may include statements of future expectations and other forward-looking statements that are based on management's current views and assumptions and involve known and unknown risks and uncertainties that could cause actual results, performance or events to differ materially from those expressed or implied in such statements. We assume no obligation to update any forward-looking statement.
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Can ESG Investing Help Prevent Future Supply-Chain Tragedies?

19/04/2018

Summary

The fashion industry heard a long-overdue wake-up call after the April 2013 Bangladesh factory collapse that killed and injured thousands. Since then, new industry agreements have improved worker safety, but one major accord will soon expire. Investors focused on ESG factors can help keep up the pressure.


Key takeaways

  • The “Accord on Factory and Building Safety in Bangladesh” brought a host of improvements to the fashion industry after the tragic 2013 building collapse, but it is set to expire in May
  • A new garment-factory accord has significant industry support, but it has stalled in a Bangladesh court; investors focused on environmental, social and governance (ESG) factors can keep up the pressure
  • Robust supply-chain management systems that prioritise the well-being and safety of workers are what permit products to be delivered at a high quality and within short lead times
Active is:
Allianz Global Investors
03-6229-0200