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.
1 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."
2 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
3 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.
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
Source: AllianzGI Global Solutions.
4 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
Source: AllianzGI Global Solutions.
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.
Dr. Wolfgang Mader,
Head of Investment & Risk Strategy,
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.
2) A performance of the strategy is not guaranteed and losses remain possible.
Investing involves risk. 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. The value of an investment and the income from it may fall as well as rise and investors may not get back the full amount invested. There is no guarantee that the strategy will succeed and losses cannot be ruled out. Investors may not get back the full amount invested.
The volatility of fund unit prices may be increased or even strongly increased. Past performance is not a reliable indicator of future results. If the currency in which the past performance is displayed differs from the currency of the country in which the investor resides, then the investor should be aware that due to the exchange rate fluctuations the performance shown may be higher or lower if converted into the investor’s local currency.
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