How to weather the storm: A roadmap for more resilient portfolios

Natasha Brook-Walters, Co-Head of Investment Strategy
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Mid Year Outlook Designs

The views expressed are those of the author at the time of writing. Other teams may hold different views and make different investment decisions. The value of your investment may become worth more or less than at the time of original investment. While any third-party data used is considered reliable, its accuracy is not guaranteed. For professional, institutional, or accredited investors only.

This is an excerpt from our 2023 Mid-year Investment Outlook, in which specialists from across our investment platform share insights on the economic and market forces that we expect to influence portfolios in the second half of the year. This is a chapter in the Investment Strategy Outlook section.

We believe that the world has entered a new era of elevated market and cycle volatility, with significant divergence across regions. The events of the first half of 2023 have certainly supported this argument. In the first quarter alone, we saw markets swing between expectations of recession and a Goldilocks scenario, which in turn was replaced by worries over banking turmoil and perhaps a deeper recession. 

Yet a more important question for many asset owners may be how to ensure their portfolios are up for the challenge, as well as prepared to take advantage of the opportunities such an environment may create. 

I think the research being done by iStrat, Wellington’s investment strategy and solutions group, sets out some important portfolio implications for allocators in this new environment. Here I outline ways in which allocators can add resilience to their portfolios, which will be critical in the new regime, before turning to three key long-term opportunities that investors may wish to pursue.

Create portfolio balance and resilience

Looking ahead, portfolios will be tested on their ability to weather market cycles. The following insights may help:

Diversifying across market regimes — When building portfolios, allocators are generally comfortable employing geographic diversification, asset class diversification, and even some factor diversification. But allocators are generally not diversified across regimes, with portfolios often tilted towards a single specific set of conditions. Our Multi-Asset Team has taken a unique approach to classifying regimes aimed at avoiding behavioral biases that can result from some traditional approaches. Its focus on “market-implied regimes” considers various characteristics (returns, volatility, correlations, etc.) of each asset class and then applies a machine-learning technique to uncover patterns and group market environments into natural clusters (i.e., regimes). 

A framework for effective active risk budgeting — The decision of where to “be active” in a portfolio is key, and our Multi-Asset Team has developed a framework to ensure this decision is balanced and disciplined for the long term. Ultimately, effective active risk budgeting requires that assets be combined in an optimal way to preserve the desired tracking error, diversify away unwanted tracking error and efficiently convert active risk into active return. To help, we offer a step-by-step framework that allocators can use in their own active risk-budgeting process. 

Incorporate climate change into asset allocation — We believe climate change will impact investment outcomes, and therefore its incorporation is critical to build portfolios that are resilient for the long term. It impacts macro-level variables, such as GDP growth and inflation; company-level dynamics, such as costs and future corporate activity; and decisions about regulation and fiscal policy. We believe these, in turn, all impact asset prices and asset allocation. What’s more, we think climate investment themes meaningfully expand the opportunity set for multi-asset portfolios and may create the opportunity for outperformance in certain areas of the market. In partnership with our Climate Research and ESG Research teams, iStrat has developed a framework that may serve to help asset allocators integrate climate change into multi-asset portfolios, and ensure their portfolios can robustly deal with potential climate scenarios.

Focus on the long-term opportunities

For asset owners, it can be challenging to resist short-term instincts in volatile environments, but we think it is important to stay focused on the long term, and to ensure portfolios can exploit structural opportunities in markets. Here we highlight three ways investors can focus on the long term.

1. Patience in managers pays off
Our team has recently done research that shows the detrimental impact on performance of focusing on short-term manager returns. For example, our research shows that even the best active managers suffer extended periods of underperformance along the way to top-quartile and even top-decile results (Figure 1). Asset owners who have a strategy to help them stay focused on the long term may be best positioned to reap the benefits of outperformance if also grounded in strong manager research capabilities.

Figure 1

2. Consider thematic investments to reduce exposure to the cycle
In this new, more volatile regime, investors can keep portfolios focused on the long term by investing in the structural change that is driving markets. Thematic investments are inherently long-term and forward-looking, and therefore may help reduce the impact of the shorter-term economic cycle on portfolio returns. Research carried out by our team found themes to be, on average, about half as sensitive to the cycle as sectors (Figure 2). 

We believe that themes focusing on social inclusion — such as health care, food and education — may be best at navigating this increased cyclicality. The success of these themes is less likely to be impacted by shorter-term growth and inflation dynamics, given their long-term tailwinds and policy support.

Figure 2

3. Think carefully about regional balance
Since the global financial crisis, it has generally paid to be overweight US equities. But in the near term, we think it’s time to consider a more diversified approach to regional exposures. One implication of increased volatility, more frequent cycles and structurally higher inflation is likely to be greater economic divergence between countries, with central banks and governments adopting a more individualised approach to policy rather than following the lead of the US. 

We think one region allocators should consider, despite performance challenges in recent years, is emerging markets. Many portfolios have reduced exposure to emerging markets, but as global economic conditions evolve, we see several reasons to think the coming decade could be a better one for EM equities, such as attractive valuations, a weaker US dollar and opportunity in China. Our research shows emerging markets (EM) equities form a very inefficient market; this creates significant opportunities for active management. It is also a market where thematic investing can allow investors to achieve better risk-balanced exposures to the long-term structural drivers of markets. Our team has done work on the best way to structure an EM equity allocation.

Bottom line

Heightened volatility will test portfolios; in a complex and evolving investment landscape, iStrat aims to help clients achieve better outcomes, providing research and solutions to meet investment challenges. Find more of our work here.


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