The current market environment, characterized by political uncertainty, low interest rates, and ever-increasing regulation, forces investment managers to seek for new return generating opportunities. Although the traditional focuses on asset class diversification and capturing risk premia still apply, three trends in traditional asset class investing are emerging. First, investment managers enlarge the investment opportunity set by broadening the investable universe and relaxing non-mandatory constraints. Second, they direct the focus towards risk factor rather than asset class exposure. Third, new asset classes are introduced and existing assets re-classified, focusing on yield rather than total return.
The current investment environment is predominantly driven by political uncertainty, low interest rates policies, and regulations perceived as dreadful. Consequently, investment managers have a hard time delivering on the promises made in the past. The investment products on the shelf no longer satisfy the needs of the investors.
Albeit investment managers still predominantly relying on diversification to manage portfolios, they try differentiating by introducing more advanced asset correlation concepts. Approaches, like copula theory or relying on Bayesian statistics, are becoming mainstream in the investment community.
Another sensible observation is that the assumption of investors getting rewarded for onboarding risk, that is, the belief in the risk premium concept, is well accepted and has even strengthened over time.
On the investor’s side, one can monitor increased risk aversion, combined with a focus on simple and transparent investing.
THREE EMERGING TRENDS
When discussing with investment managers, both on the portfolio management and on the business development side, three emerging trends can be identified.
INVESTMENT UNIVERSE BROADENING
Many investment managers believe that being restricted to only invest in a pre-defined benchmark universe is too limiting. Increasingly, investment products invest heavily in non-benchmark assets that meet a certain set of criteria. This can especially be observed in the fixed income product space, where, for example, investing in emerging market bonds as part of a global bond product becomes mainstream. Investment managers push for being allowed to take short positions, rather than only being restricted in long positions. In contrast with earlier days, the focus is not on generating return through complex structures, but rather than through exploiting additional opportunities.
In addition, there exists a trend to dilute investment guidelines, only retaining those required by the regulator.
Key challenges. The main challenge of this trend is that the characteristics of individual investment products get diluted, making it harder for investors to select appropriate products and manage their own overall portfolio risk. The focus of the investment manager shifts from quality to quantity of investment decisions, which is not necessarily in the interest of the investors.
Benefits for the investor. By following this trend, investment managers can broaden their investment opportunity set. This allows better exploiting the value behind the fundamental law of active management, which states that the investment performance is proportional to the square root of the number of investment opportunities successfully exploited. Assuming an unchanged investment coefficient, that is, investment decision quality, investment performance can be improved.
- Start with a clear definition of the added value promised to the investors (in terms of opportunity set, return, and risk) and stick to it
- Define the broadest investment universe aligned with the promises made
- Discard all restrictions that prevent delivering upon the promises made (both from a return and risk perspective)
FOCUSING ON RISK FACTOR EXPOSURE
In recent years, numerous investment products have been launched focusing on risk factor exposure rather than asset exposure. They can be subdivided into two categories, those that focus on a single risk factor and those that manage exposure to multiple risk factors in a similar way that traditional products manage exposure to multiple asset classes. The most prominent examples of single risk factor products are smart beta products. Investors can invest in or hedge against a specific risk, like for example, inflation risk, growth risk, or volatility. In multi-risk factor investment products, investment managers manage risk by diversifying the exposure along risk factors rather than asset classes.
Key challenges. A major challenge, especially stemming from single risk factor investment products, like smart beta products, is that the decision of which risks to onboard is transferred from the investment manager to the investor. Investors have a harder time forecasting risk factors than asset classes (for some investors, this is beneficial, rather than a challenge). Multi-risk factor investment products are still too often hard to understand which makes them inappropriate for many investors.
Benefits for the investor. By investing in single risk factor investment products, investors can better manage the risks they want to onboard and avoid spurious risks. Risk exposure can be better aligned with investment goals, for example, as advocated by goal-based investing. Multi-risk factor investment products, on the other hand, offer improved diversification of risks and a better alignment with the concept of risk premia.
- Focus on those risk factors that are relevant to investors managing their liability risks
- Develop investment products that seek exposure to risk factors which are well understood by the investors and have been academically validated
- Avoid mixing risk factor exposure approaches with asset class exposure approaches
SEARCHING FOR YIELD IN NEW ASSET CLASSES
A third trend seen is the defined of new asset classes and re-classification of existing assets, focusing on yield rather than total return. Table 1 shows the old and new world classification side-by-side. Although this trend may seem quite like the risk factor trend, it differs in two key aspects. First, it focuses on return rather than risk. And second, it relies on an asset re-classification that most investors feel comfortable with.
Benefits for the investor. Investors can benefit from a re-classification of assets focusing on yield rather than total return, by allowing for better exposure management through decomposing asset characteristics. In contracts with the risk factor exposure trend, the so-called new world asset reclassification scheme is easy to understand and implement, even though not free from subjective bias.
- Re-classify assets into categories that are easy to understand by investors
- Focus on the yield / cash-flow generating capabilities of assets when defining new asset classes rather than total return
FOOD FOR THROUGHT
The three emerging trends in traditional asset class investing identified still rely on taking an investment product-based strategy view, rather than being customer centric. Quoting Alex Osterwalder “(Swiss) bankers searching in the wrong place? Customer value propositions are the problem, not a lack of technology…” or investment capabilities. A key challenge is to relate the identified trends to the investor’s needs and investment goals. Investment concepts need to add value for the investor (and not only for the investment manager), be transparent, and easy to understand, both from a return as well as from a risk perspective.