Global investors face the difficult task of setting asset allocation in an environment where the global macro-economic backdrop suggests chaos and downside risk, but markets continue to perform strongly.
Michael Hunstad, president of Northern Trust Asset Management, told the Fiduciary Investors Symposium at Stanford University that investors have “a very, very tough situation in front of us” to reconcile those apparently contradictory scenarios.
“You have this strange situation of a lot of turmoil in the backdrop, both from an economic and a political perspective; but you also have this shooting-the-lights-out kind of performance in most major asset classes,” Hunstad said.
“So how do we deal with that? Our house view is that the world currently has fat tails on both sides. Clearly, there’s a lot of downside risk, but there is an equal amount and probably even more, of an upside risk inherent to the markets as well.”
Hunstad said that a striking characteristic of the US economy is that about 70 per cent of GDP is consumption based, which is not unusual for a developed market, but “within that 70 per cent a large portion of that consumption accrues to the top, call it, one or two quintiles of wealthiest consumers in the country”.
Hunstad said equity markets have risen 60 per cent over the past two years; interest rates are increasing, which means interest income is on the rise; and home prices generally have increased.
“Those top quintiles of the wealthiest consumers in the United States are wealthier than they have ever been by a huge margin,” he said.
“Some estimates suggest between about $120 trillion in total wealth prior to Covid, now about $180 trillion, so a 50 per cent increase in total wealth. Why does that matter? Because that, in our view, is the gas tank for growth going forward.”
Stefano Cavaglia, senior portfolio manager, total portfolio management, at the State of Wisconsin Investment Board told the symposium that “equity exposure is something you want in the long run; the question is, what do you do in the short run to mitigate any of these risks?”
“I think it’s clear, from what we’ve observed and what we’ve heard that the so-called tail risk is more significant now,” he said.
“Tail risk is often shunned as a good way to lose money on an ongoing basis, and we’ve actually spent quite a bit of time thinking about it.”
Clear on risk
Cavaglia said that to protect portfolios against tail risk, investors need to be clear on what the actual risk is that they are seeking to hedge, remember that a hedge cannot be static, and understand managers exhibit skill (or lack of it) in hedging just as much as they do in asset allocation or stock selection.
“Are we trying to hedge an unusually large event or are we trying to hedge something in the short run, and a small event? How you structure that hedge is critical to the cost that you incur,” he said.
“The second [point] is that these things are not set-and-forget. There’s a temptation to say, ‘Oh, I put my hedge on, and I’m done’. No, we’ve found out that, essentially, how you rebalance in the event of a drawdown is quite important.
“And there is, across managers who do this type of work, varying skill, and that is something you can actually quantify on how they reap those extra returns and how they rebalance those losses or those gains, whichever one they may be.”
Benoit Anne, senior managing director and head of market insights at MFS Investment Management, said “all those tensions and frictions and geopolitical risks that we’ve heard about… have two major investment implications”, the first being to underline the importance of global diversification.
“What we’ve learned this year is the US can actually be a source of major policy uncertainty, micro-volatility, and in the context of maybe a weakening dollar, some have learned the hard way a global diversification approach makes total sense,” he said.
“The second massive investment implication of all those tensions is that it reinforces the case for active management, all that volatility, all that tension, creates differentiation, creates divergences, unsynchronised micro cycles, and all that can actually offer opportunities for an active asset manager.”
Cavaglia said investors can’t be certain about the future. All they can do is make as highly educated guesses as possible and remain cognisant of the fact that they do not have all the answers.
“I want to offer, more than anything, a framework for how to think about these things,” he said.
“Right, now, there are multiple theories about whether an asset is overvalued or undervalued, and I can come up with lots of stories, and they’re all fair. The way I’ve approached the problem over the years is [to accept] I don’t know what the theory is.
“If I look at history, I scratch my head and I go, I can’t find a model that can explain these events, right? So then I say, okay, fine, what do I then do?”
A century of data
Cavaglia said there is about a century of data that describe previous “unusual” or “alternative” events, which takes investors back to “this tail question: the tail matters to different people in different ways”.
“There’s no shortcut. I don’t have the magical model. I don’t have the magical utility function. The way we approach this is, here’s a bunch of portfolios. Here’s what can happen to you in the short run, and here’s what can happen to you in the long run. And you have to, or an investment committee or other, have to balance those trade-offs.”
Hunstad said Northern Trust’s asset allocation is “certainly risk-on [but] it does not mean that we can be complacent about risk [by] any stretch of the imagination”
“I would say, to Benoit’s comment, we are still very much in the diversification camp as well, recognising that there is macroeconomic inconsistency across countries that there hasn’t been in a very, very long time. We want to take advantage of that same thing as well. There’s a big, big, big, fat tail on the left, and we’re very cautious about that. We want to basically construct our portfolios to minimise that as much as we can.”
Anne said that, at the risk of contradicting his earlier view that he did not want to be over-exposed to the US, “I strongly believe there’s a strong bullish case for the US long-term”.
“Do I believe that the country is going through a productivity miracle? Yes, I do. I believe that the long-term growth potential in the US is higher than in any other developed markets,” he said.
“Do I believe that maybe indeed, the valuation story in the US is actually debatable over the long term? Yes, I do.
“There’s a strong case for long term US equity exposure. It’s just that the near term doesn’t look that great.”
