How to adapt portfolios to today’s challenges

“Market conditions are undoubtedly becoming more challenging.”

That comment comes from Unigestion CEO Fiona Frick in a report on adapting to complex markets. Though she expects sychronized global growth to continue, market stress events are likely to become more prevalent this year, she says, as inflation risks push central banks into tightening mode.

The resulting challenging market environment means that “a simple investment approach, which has proved very successful in recent years, will no longer work, and more sophisticated solutions will be needed,” says Frick.

Read: Be victorious over volatility

Her firm constructs portfolios using measures beyond volatility to assess risk, such as potential losses on capital, liquidity, skewness and tail risk.

“In addition, we expect correlation shocks to occur more often at this stage of the economic cycle, fuelled by tighter liquidity and rising anxiety about monetary policy,” she says. “The correlation between equities and bonds will evolve as bond yields rise and become more attractive relative to stock ‘yields.’ “

Here are investing insights to adapt portfolios to today’s market.

• Use dynamic asset allocation with intelligent diversification

Portfolios should be tilted toward assets that profit from a growth environment, while taking into account rising inflation risk. “However, with market stress events likely to occur more often, a diversified and dynamic approach will be imperative,” says Frick.

To diversify intelligently, she suggests investing in assets that respond differently to common factors. “Diversification into alternative risk premia with a low correlation to traditional assets, such as carry, equity long/short factors or trend-following strategies, can improve the overall risk-return profile of an asset portfolio, especially when traditional assets are looking expensive,” she says.

Further, when risk pricing in the market isn’t aligned with true risk levels, investors should have flexibility to lower portfolio beta as required, through opportunistic hedging in currency and options markets.

• Invest in equities but manage risk

Despite equities traditionally performing well during periods of rising inflation and rising rates, today’s high valuations mean investors must be selective about equity risk.

An active strategy allows investors to “target intended, remunerated risk more precisely,” says Frick. For example, with monetary tightening expected, investors must consider the sensitivity of their equity portfolios to sovereign bonds and protect portfolios as much as possible through active stock selection and sector allocation.

Read: What’s ahead for Canadian and U.S. equities

• Selectively allocate to private equity

While private equity continues to be attractive, valuations are on the high side. “Finding good investment opportunities and maintaining price discipline will be the biggest challenges for private equity investors this year,” says Frick.

She suggests investors find companies that can deliver required returns without relying solely on leveraged and multiple arbitrage.

“Given the level of competition, we prefer strategies that allow sourcing deals outside of large auctions, such as small and mid-market buyouts, or those with a sector focus,” she says. “Some caution will be needed as private equity shows some correlation with public equity and high yield bonds, both of which are looking expensive.”

For more details, read the full Unigestion report.

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