Liquid alternatives in multi-asset portfolios are likely to be indispensable in the future
Managers of multi-asset portfolios are facing major challenges. The traditional allocation to equities and bonds is unlikely to be a suitable way for investors to achieve a reasonable risk/return ratio in the future. This is due to several factors: the persistently low yield environment over the long term, the significant overall decline in return expectations for all conventional asset classes, and increased uncertainty, which is reflected in higher tail risks for equities and bonds.
Diversification with government bonds no longer works so well
In the case of bonds, there is another aspect in addition to the low return expectations: they are no longer as good a diversifier as they used to be. "If you take a look at weekly returns, government bonds provided positive returns two out of three times over the last two decades when equity returns were negative. So they provided a good balance of risk," says Björn Jesch, Chief Investment Officer for EMEA and Global Head of Multi-Asset and Solutions at DWS. But that has changed recently. The negative correlation is no longer as stable as it was in the last twenty years. For multi-asset portfolios, this is a problem.
Jesch rejects the obvious solution to compensate for the low yield expectations, namely to rely on longer maturities or on bonds with lower credit ratings and correspondingly higher interest premia. "This is not expedient. Both options increase the risk profile of a portfolio."
Negative correlation of equities and bonds is not set
Source: DWS Investment GmbH, as of: end of May 2021
There are solutions, though not simple ones. "In our view, liquid alternatives are an indispensable component of a sustainable, balanced portfolio," says Jesch. The spectrum of liquid alternatives is wide – ranging from REITS, listed infrastructure and commodities to hedge fund strategies and cross-asset risk-premia strategies. Let us take a look at alternative risk-premia strategies. Hundreds of different premia have been studied in recent years; one could already speak of a factor zoo due to the quantity. "Some of the factors are certainly promising, while others are useless and many others redundant," says Jesch, describing the problem.
Strategies sought to cushion negative stock market returns
Looking at one of the simplest strategies to offset negative stock market returns – buying and rolling at-the-money put options – shows that such a strategy does its job when equity market returns are significantly negative. In times of normal market performance, however, performance suffers significantly. The strategy is therefore not the best choice to cushion extreme risks. Vola Carry strategies, a combination of put options on an equity index and call options on the index's implied volatility, offer a better option.
"In our study, we looked at a wide variety of strategies and found very large differences in returns across the different sub-asset classes of liquid alternatives," says Jesch. In order to achieve the best possible result, it is important to recognize the differences. Our credo is therefore: "Know your premia". Only those who really understand the different premia can take sensible decisions. To do this, investors should always consider what characteristics their investments should have. Some alternative investment instruments are well suited to collect additional risk premia. Others have a special quality as a hedging instrument in the portfolio. Ultimately, the investment approach chosen must be based on the goal that the investor is pursuing.
Read the full study here.
Sabina Diaz Duque
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About DWS Group
DWS Group (DWS) is one of the world's leading asset managers with EUR 820bn of assets under management (as of 31 March 2021). Building on more than 60 years of experience, it has a reputation for excellence in Germany, Europe, the Americas and Asia. DWS is recognized by clients globally as a trusted source for integrated investment solutions, stability and innovation across a full spectrum of investment disciplines.
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