June's Brexit vote was another reminder of the difficult road ahead for investors. The news jolted markets and sent advisers and their clients into yet another huddle session to adjust or reinforce long-term plans. While a significant event, the truth is Brexit is just one of many challenges advisers must navigate on behalf of their clients. The news doesn't change the fact that these are tumultuous times and finding growth is one of the greatest obstacles we all face.
Earlier this year, we talked to financial advisers about their clients' expectations. Most of these advisers said that their clients expect returns of 5%-7% a year for the next three years. In a growth-starved global economic environment with low yields and few cheap assets, it's a lofty, maybe even unachievable, demand. And add to that an almost steady stream of market shocks and investor worries, the path forward is anything but clear. This is the allocator's dilemma.
For investors thinking beyond today's headlines, there are much deeper, personalized challenges for which they rely on their portfolios to overcome, whether it's to afford increased retirement expenses, cover escalating healthcare costs or to multiply savings to provide for educational or housing requirements. For these reasons, advisers who think about risk differently can be better positioned to serve their clients in a low-return environment. For some, the following opportunities may be the difference-makers:
1. Shift the Equity-Bond Mix — The traditional 60/40 equity/bond portfolio with a domestic bias has generated greater than 10% compound capital growth for close to four decades. Given that much of the return on core bonds was driven by high starting coupons and capital appreciation as rates fell by close to 90%, the unprecedented low yields on core bonds makes a repeat performance mathematically impossible.
2. Look Around the World — Valuations on equity markets outside the U.S. are generally more attractive and June's Brexit news made them even more so. Advisers may want to consider aligning allocations closer to current market capitalization by region. This would suggest having as much as 50% of equity exposure in non-U.S. equities, a stretch for some home-biased U.S. portfolios. Our adviser research shows that about 55% are taking advantage of attractive valuations with higher allocations to international equities; 45% are positioned for long-term growth potential in emerging markets despite near-term risks.
3. Make Equity Risk Exposure Work Harder — Find ways of expressing equity exposure that offer a high-degree of diversification and that seek to generate enhanced growth by taking better risk. The goal is to grow capital while being mindful of volatility and downside participation during periods of duress. While this is every investor's goal, a new breed of ETFs incorporate this thinking into the strategy, and advisors appear to be gravitating in this direction. Forty-five percent of investment managers expect to increase allocations to ETFs in the next 12 months; 41% say those ETFs will be strategic or smart beta strategies.
4. Cast a Global Net for Smaller Company Growth Potential — Most investors have U.S. small caps in their portfolios, but are likely underexposed to dynamic smaller companies outside of the U.S. These companies account for two-thirds of the 6,000 or so small cap stocks globally and generally offer more attractive entry valuations than U.S. small caps.
5. Think beyond Bonds for Risk Reduction — In a rising, or even stable, rate environment, core bonds may offer low to negative real returns and they may also lose a degree of their risk buffering capacity when equities are under pressure. Focus on identifying building blocks that have the prospect of generating positive real returns, while offering defensive qualities during market turbulence. Our research shows that 64% of advisers say they are sticking with bonds or other alternatives with the prospect of rising interest rates already reflected in their portfolios.
6. Enhance Yield and Total Return — Beyond core bonds, other higher-yielding assets such as high-yield credit, developing market bonds and various other cash flow-generating real assets, where yields are two-to-three times higher, may respond more favorably in a rising rate environment, while providing higher total returns. These categories are generally beat-up and unloved, which makes the move (or even rebalancing to them) challenging to explain to clients fixated on trailing performance. Advisers focused on future income returns should contemplate exposure here.
7. Hedge Against Future Inflation — While imminent inflation is unlikely, history would suggest that periods of large-scale debt buildups and massive new money creation often precipitate increasing future inflation, if only as the most expedient means to reduce governmental debt overhangs. This does not suggest an allocation to inflation hedges so large as to crowd out assets that may be more productive in the current low inflation environment, but the inclusion of such exposures increases portfolio resilience across macro environments and can be scaled as future conditions warrant.
Ted Lucas is the head of systematic strategies and ETFs at Hartford Funds
