As global economy converges to more stable rather than rapid growth, debt level and growth dynamics keep interest rates relatively low, and inflation remains muted in developed world, investors are faced with broadly fully-valued market. Macroeconomic variables are favorable for equity investing relative to other asset classes, and investors can employ simple approaches to enhance their total returns while keeping risk at minimum.
Enhance the “Core” by Seeking Outperformance Strategies
Seeking higher returns does not always mean to take additional risk. Most investors follow strategic allocation to global equities asset classes, including domestic US equities, international equities and emerging markets equities portfolios.
Smart beta is an investment style where the investment manager passively follows an index that was designed to take advantage of perceived systematic biases and inefficiencies in the market. Smart beta emphasizes the use of alternative index construction rules to traditional market-capitalization-based indices. It systematically selects weighting and rebalancing the portfolio holdings based on the respective characteristics.
Smart beta offers an option beyond traditional passive and active equity investing. It seeks outperformance through a systematic approach that breaks the link between price and portfolio weight to capitalize on market inefficiencies. Some smart-beta fund returns illustrate that smart beta strategies can differ a lot in the short term. While there is short-term sector risk as one sector can make or break a group of portfolios over the short term.
Portable alpha is the return of an investment portfolio with zero market risk, or beta. As it is independent of the direction and the magnitude of market movements, portable alpha represents an investment manager’s skill in selecting investments. By providing target market exposure, an alpha is a product of the correlation between the portfolio and the market beta. It is typically uncorrelated to betas and other alphas, with higher Sharpe ratios.
Portable alpha utilizes an independent alpha source. In most portable alpha strategies, market exposure is gained through market-linked instruments such as futures or swaps, which require only a small outlay of cash and allows the investment manager to both capture the market return and actively manage the cash in the portfolio in a liquid strategy, such as an absolute return bond portfolio, enhanced cash, enhanced treasury inflation-protected securities (TIPS), and long-duration bond.
Dividend as a Stable Source of Return
Equity total returns have two components, capital appreciation and dividends. When the markets are characterized by broad multiple expansion, which is typically driven by declining interest rates, the contribution from capital appreciation will dominates.
While with fuller valuation and macroeconomic backdrop, companies will likely report modest earnings growth at best, and investors will gain less from capital appreciation. Dividends, on the other hand, are likely to make up a greater portion of equity returns which can also be a more stable source. However, stocks that simply offer yield may struggle in a rising rate environment. Investors can benefit from investing in global dividend portfolios when rates are lower or decreasing, and they should focus on the growing free cash flow of companies, as well as management’s being committed to dividend growth.
Reduce Downside Risk
Investors can participate in equity markets while mitigating downside risk. Downside risk management is complex and investors need to understand the nature of volatility, the costs to be involved, assess how much they are willing to pay for protection against an event affecting their portfolio given the probability of that event occurring, and the trade-off between any potential gains and losses.
In addition to diversification, lower-volatility equity strategies can also offer the potential for asymmetric up and down market returns. Specifically, long/short equity strategies may be a good low-volatility solution, which are effective complement to long-only allocations. Additionally, managed futures and global macro strategies possess some risk mitigation properties as part of a traditional strategy to produce favorable returns at an appropriate level of risk.