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The market outlook is without question a challenging one, and there is no quick fix and no single “bridge” that will get asset owners where they need to go. But I believe there are effective incremental steps that can be taken to help improve a portfolio’s return potential, including the following ideas.
To demonstrate the potential benefit of defensive investing, Figure 1 illustrates a hypothetical strategy that captures 95% of the return of the S&P 500 in up months but only 85% in down months. Not surprisingly, the strategy adds value when the S&P 500 falls, including during bear markets (shaded areas). But it also holds its own in bull markets, when it might be expected to struggle. After all, even in a bull market there are ups and downs, and a strategy that can limit downside can leverage the power of compounding to improve results over time.
Asset owners with a traditional equity portfolio (growth, value, core) may miss out on factors related to defensiveness, such as price stability (e.g., low volatility) and earnings stability. One idea for filling this gap is “compounders” — equity strategies focused on companies with high and stable free-cash-flow yield and the potential to grow modestly but steadily over time, all in the pursuit of high-single-digit or low-double-digit returns. This category includes portfolio managers we think of as “core compounders,” based on the way they pick companies, as well as listed infrastructure and listed real estate strategies.
High-single-digit or low-double-digit returns could represent significant alpha in the next decade. In addition, valuation could be a tailwind for some defensive approaches, given the category’s weak COVID-era performance. Some of these strategies (e.g., listed infrastructure) may also offer the benefit of inflation hedging, which could add to their appeal in the current environment. Lastly, it is possible that in some scenarios, fixed income will be a less effective hedge against an equity market sell-off than it has been historically, which could make defensive equities all the more attractive.
I define thematic investing as trying to capture structural trends that will change the world over a period of five to 10 years (or more) in ways the market hasn’t fully recognized. Today, fintech, energy infrastructure, and emerging market development are among the themes I’m most excited about.
Opportunistic investing is about taking advantage of market dislocations or negative investor sentiment, which can create massive tailwinds when fundamentals (and sentiment) inflect — a process that often plays out over a shorter cycle (three to five years) than thematic. Opportunistic investors seek to “monetize” a longer time horizon by being a liquidity provider when the market is shying away from a region, asset class, or approach. Given that there is ample liquidity today, I see fewer of these opportunities at the moment, but Japan may fit the bill and China could soon as well.
Both thematic and opportunistic investments can potentially benefit from tailwinds that aren’t reliant on the business cycle or economic growth, which means they are less dependent on the state of the broad capital markets and may add some diversification to a portfolio. Success factors include identifying the right themes or opportunities and then finding the related securities that are most attractive at any given point in the cycle.
Here’s a complete list of my “stepping stones” investment ideas, including thoughts on equities, fixed income, and private equity.
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