The Gordian Knot of asset allocation and why investors need alternatives

There is a Gordian Knot with asset allocation as we move into 2016. The problem is simple but fundamental to all asset allocation this year. If interest rates are going higher, what happens if stocks do not go higher. Moving out of bonds and not stocks may not protect principal.  The premise on switching between these two assets classes is based on the negative relationship between stock and bonds that have existed for a fairly long time albeit not guaranteed. Investors are in a difficult situation of the negative correlation does not exist in 2016.

The 2016 assumption is that the Fed will normalize rate and we will thus see higher rates across the yield curve. The higher rates are based on expected higher inflation and higher growth. If there is higher growth, there will be an expectation for higher earnings based on higher sales which will boost stock prices. Similarly, there will be higher inflation if there is a higher growth. Because earnings are adjusted with inflation, equities will be a better asset or hedge if there is inflation. The result is a negative correlation between stock and bonds. If you don't like bonds, you should like stocks. If you cut your bond exposure, then you should increase stock exposure. But what if this relationship does to hold?

How do you protection principal and reduce risk if the negative correlation between stocks and bonds does not hold in 2016. You are stuck in a horrible investment situation if rates rise and stocks fall.  This is easily possible if the risk premium on bonds increases even though there is no further economic growth. It is possible the Fed raises rates in a bad economic environment. The only solution to this problem is to find non-correlated assets to stocks and bonds. You have to find alpha generators. 

Alternatives serve as the solution to this two asset class allocation knot problem. This is why the recent JP Morgan Institutional Investors 2016 Survey shows the largest net change in alternative allocation decisions going to global macro. 16% of survey participants expect to add to this strategy.  Unconstrained long/short beta can get around the problem of changing asset class correlations. This knot solution is why there has been continued interest in alternatives even though there has been significant under-performance relative to hedge fund return targets. 

Natixis survey - what are institutional investors thinking for 2016?

Many firms are now engaging in surveys to provide insight on the direction of asset allocation choices of large investors. Natixis Global Asset Management just released their 2016 survey of institutional investors which provides interesting reading. It tells us that institutions want efficient diversification, different asset class and strategy choices that efficiently use capital.  The top objective for institutions is not about growing or preserving capital but achieving the highest risk adjusted returns. This plays nicely into the higher demand for alternative investments. The one thing that hedge funds do well is more efficiently use capital and this seems to be the desire of investors.

Of course the big elephant in the room for any investor is the threat of higher interest rates from a Fed normalization. 2/3rds of institutional investors plan to shorten bond durations as a way to respond to this threat. Unfortunately, lower durations comes at the cost of lower yields.  Protection against rate increases will cost yield in the short-run and lead to lower realized portfolio returns. This is another reason for the increased demand for alternatives.

The largest decrease in allocations will be to the fixed income asset class. The largest increases will be toward equities and private equity. It is interesting that while rates are expected to increase, there is a desire to hold more equity during a period of Fed normalization. The expectations is that real rates will rise from improved growth and there will be higher inflation based on a strong economy.  Equities are being viewed as an inflation hedge with expectations for higher earnings. There is the implicit belief that a bad bond environment is a good stock environment based on continued negative correlation between the two main asset classes. That is an assumption that may not be realized.

Still, there is a strong desire for holding alternatives as a means to break-out of the two asset diversification between stocks and bonds. From the survey, the main driver for holding alternatives is diversification and not alpha generation. The value of risk mitigation falls right behind the demand for alpha generation. 

The core problem with 2016 for institutional investors is clear. There is an expectations that rates will rise, but the alternative of holding more equities may not be palatable. This means that alternative investments will have to serve as the go-to place for diversification and risk control.

Mercer view for 2016 - what does it mean for portfolio construction?

Mercer consulting announced their themes for 2016.  Their four themes are not surprising, but it is still important to review them and think about how they can be exploited in the global macro space. The overriding theme is that investors will be facing a low return environment, or more importantly, we are not in a positive long-only environment. In the short-run, holding beta exposure will not get you to your return dreams. The four themes are:

1. Reduced liquidity for liquid assets
2. A maturing credit cycle
3. A tilt form beta to alpha
4. Think long-term

The reduced liquidity theme has been the talk of both investors and regulators. Investors are getting more risk averse given the potential for liquidity events. Police-makers either do not want to admit their is a problem or believe they are not the cause of any liquidity shortfall. Nevertheless, they have increased their focus on macro prudential policies which include monitoring liquidity. Our view is that a reduced liquidity environment calls for greater exposure to short-term trading strategies. Liquidity providers will be rewarded.

A maturing credit cycle is evident with the explosion of high yield credit spreads. Credit is becoming scarcer and investor are asking for greater risk premia. This credit repricing process is just beginning, so the our view is that switching out of credit in the short run is a good defensive strategy.

The tilt from beta to alpha is justified given we are likely to see further repricing of risk in equities. While the ECB, PBOC, and BOJ are all adding liquidity, the Fed's shift to normalization creates a potential headwind for holding risky assets. Low volatility has continued even after the spike of last August. This is likely to change. We view that market correlations will decline given the decoupling of policies. This means that relative value trades will be better rewarded than buy and hold directional positions.  Find alpha that exploits lower market correlations.

The "think long-term" view is a catch-all for the fact that, in the short-run, uncertainty will be high and the ability of investors to get direction right may be difficult. This may be in conflict with the idea of active trading in a illiquid world, but we see this as the other end of the liquidity spectrum. In this world, holding long-term strategy allocations make sense if you cannot or do not want to take advantage of changes in risk aversion and liquidity. 

Sentiment-driven market behavior - feedback or snap-back?

I believe that to a large extent, herding is at play. If other investors sell, it must be because they know something you do not know. Thus, you should sell…. So how much should we worry? This is where economics… gives the dreaded two-handed answer. If it becomes clear… that fundamentals are in fact not so bad, stock prices will recover…. [But] the stock market slump… can become self-fulfilling…. Hope for the first… worry about the second.
- Olivier Blanchard  on the current markets 

Call it animal spirits, confidence problems, sunspots, self-fulfilling prophecies, sentiment, herding, noise traders, risk-on/risk-off, or multiple near-rational equilibrium, the markets are not following the fundamental news. Economist have a hard time when market move and there is not a clear link to fundamentals. The story that links fundamentals with the price action is often a complex form of expectations and game theory. Economist do not have a good or consistent name for this behavior of prices unrelated to news. The market may be turning because there is a change in expectations of fundamentals, but more importantly, there is a change in sentiment and  markets are having a crisis of confidence. 

We express this divergence in behavior as a difference between exogenous versus endogenous risk. The endogenous risk or the risk from trading and price action is driving the markets. The exogenous risks form change in fundamentals have not been a critical driver of prices. This is a time when systematic trading based on price should be very effective. Don't focus on the fundamentals, but follow the trend and price action. The market may be herding for a number of reasons. It could be a high level of uncertainty. There could be a new assessment in expectations. The reason is not always important. It is rational to follow the price action during these periods of transition. 

There could be a market snap-back from this decline. Generally, there are a lot of price snap-backs. Markets are usually mean-reverting or convergent, but there are times when there is a change in confidence such that mean-fleeing or divergence in markets is the dominant theme. This seems to be the current state. In this environment the price decline can cause a negative feedback loop and force business confidence lower. The markets will be in real trouble if that happens.