The new low-return, high-volatility environment requires broadly diversified portfolios, dynamic decision-making and rigorous due diligence, which is beyond the internal capacity of most small funds under $10 billion, warns Russell Investment’s global chief investment officer Peter Gunning.
He says smaller funds must decide if it is cost effective and even possible to internally manage investment portfolios that can successfully adapt to this new fast-changing environment.
“If you are not on this 24/7, in reality, you are going to miss opportunities,” Gunning says. “If you are waiting for the monthly meeting of the investment committee, markets might have been up and down a lot in between and you may have done nothing.”
Gunning believes the current market conditions are here to stay for at least the medium term and if funds are going to achieve their return objectives, they need to take a comprehensive look at their investment processes.
“I would argue if you are probably under $10 billion, it (insourcing investment management) is probably not worth doing. You can do it but you are doing it in a hybrid model,” he says.
Russell manages more than $150 billion for clients that typically outsource their investment decisions to the global asset manager.
Three-pronged approach to volatility
Managing the current environment requires a threefold response, according to Gunning.
The first is to look to greater diversity of assets, both listed and unlisted. This multi-asset solution should be implemented with what he calls an “open architecture”.
This approach ensures that the full suite of options is available in any one asset class to achieve a return objective, with the investment team not locked into any one manager or proprietary product.
Gunning says that dynamic asset allocation should involve a rebalancing back to the strategic asset allocation when valuations change, altering the weight of the particular asset class in the portfolio.
It is an approach that has been championed by the investment teams of such large funds as the $165-billion Canadian Pension Plan (CPP).
Secondly, funds should look to ensure dynamic decision-making that can adapt to fast-changing market conditions, both within an asset class and across asset classes.
“Volatility isn’t necessarily a bad thing. It just means that the investment process may need to adapt to it,” Gunning says.
“So, it is all about being more dynamic in terms of the asset allocation decisions across that diverse set of building blocks.”
Finally, Gunning says, due diligence has moved well beyond the sphere of manager selection and now demands ongoing oversight of operations to minimise risk.
In a low-return environment, part of this is due diligence to ensure efficient execution across a diversified portfolio so there is not what he calls “implementation leakage” because every basis point is crucial.
‘It is a whole lot of small things, particularly when returns are low, but they all add up,” he says.
Equities are not dead
Looking ahead, Gunning says that the fund is cautiously optimistic about equities that “may surprise on the upside”.
“We think that on a relative basis equities are a fairly good place to put your money,” he says.
Gunning has previously warned about the need for investors to actively manage their fixed income portfolios, saying that typical indexes expose investors to the biggest debtors.
In addition, he notes that fixed income investors should look carefully at their sovereign exposure, raising concerns that a bubble is emerging in some segments of the sovereign debt universe.
“There is definitely on the sovereign side a bond bubble developing. When you think about 10-year treasuries at 1.5 per cent and two-year government auctions going off at negative, TIPS – five-year and ten-year – are very low.”
“Interest rates can only go so far, we wouldn’t say that equities will come roaring back, but on a relative basis we are more positively disposed to equities than sovereign bonds. We do think there is a reasonable case to maintain positions in high quality corporates and high yield.”
In its fixed income portfolio, Russell currently has what Gunning describes as a “systematic overweight to credit”.
Regionally, Gunning sees that the US may provide better outcomes than Europe, which will be “difficult at best”, and, predicts a soft landing for China.
“On a relative basis, North America is probably providing the best opportunities, followed by Asia and then Europe, on the equity side.”