Nervousness has increased again over recent months and various asset classes tend to react differently. Gilts have performed strongly in the quarter to date but global equity markets have posted negative returns.
Market cycles and, hence investors’ preferences, have become shorter and more volatile. The amount of days the FTSE 100 moved more than 3 per cent was roughly five times higher in the 2000s than in the 1990s. Periods of strong performance of riskier asset classes, which used to spread over various years in the 1990s and 2000s, can now be reduced to months or even weeks of very strong performance, followed by periods of strong negative price action of riskier assets.
To capture periods of strong performance, we believe it is important to remain invested. Robust asset allocation has become of increased importance over the last few years but identifying the right asset mix matching investor risk and attitude can be very difficult.
How should investors construct their optimal portfolio to provide diversification benefits? For example, the correlation of returns from emerging market equities and Asia excluding Japan equities was almost one over the last decade. Just combining these two equity markets in a portfolio would have had almost no impact on its risk-return profile but combining emerging market equities with global government bonds would have contributed to the desired effect, as the correlation between the two was only 0.1 over the last 10 years.
The correlation between asset classes is a hugely important factor but so is single asset class volatility. The third set of input data when constructing a portfolio should be expected returns for asset classes under consideration. It is key to use forward-looking data rather than historic returns. Assumptions for future returns can be derived by considering how risk premiums for the asset classes are expected to be affected, for example by macroeconomic factors such as inflation.
Considering only one set of input data – expected returns for the asset classes used, single asset class volatility and correlations between asset class returns – does not account for any errors potentially made in the assumptions. To account for this, a resampling technique should be used and simulation techniques should be employed to stress-test the proposed asset mix. Stress-testing helps to understand better how the portfolio might behave in different market situations, and assess whether the asset allocator is comfortable with portfolio behaviour displayed.
Although we consider current security valuation levels to be favourable for riskier asset classes such as equities and less attractive for developed market government bonds, we recognise macroeconomic tail risks remain elevated and continue to favour a broadly diversified investment approach.
Meike Bliebenicht is co-manager of HSBC world index funds at HSBC Global Asset Management