Many have forecast that stock market returns in the next 10 years will not match those of the last 10 years – or even the last 35 years. Instead, they expect lower returns and higher volatility. What might that mean for the process of asset allocation, as well as the potential risk and return for investors? Ivy Investments brought together three experienced investment pros to explore the issues and factors in building a portfolio now.
Q: The stock market bull has been running for several years. Do we need to re-define a "balanced" portfolio going forward?
Most assets are rich now relative to historical precedent, so it raises a real question about whether we’ll continue to see that historical level of returns going forward. I think it will be extremely challenging and not that probable. In market environments like the one we’re in now, you must be more diversified than before. Over about the past five years, one of the best-returning portfolios was a traditional balanced portfolio of 60% equity and 40% fixed income with a bias toward the U.S.
Domestic equities have outperformed almost any other risk asset and there have been some notable returns within fixed income as well. I think both have outperformed market expectations. Given the fact that current multiples in equities are above historical levels and fixed income spreads are tighter than historical averages, I think we now are in a lower-return environment. I do think active management now is a key factor in finding opportunities to maximize risk-adjusted returns.
In general, we think opportunities are better overseas than they are in the U.S. The valuations of both foreign developed and emerging market equities are more reasonable now, relative to their historical averages, and also are more reasonable when compared to domestic equities. We think the same is true in fixed income. Look no further than emerging market debt this year, which has been among the highestreturning asset classes across the globe.
Q: How can emerging markets fit in a portfolio now?
U.S. equities are trading at nearly 18 times forward earnings, which is high relative to historical levels. Foreign developed markets are trading at about 14 times forward earnings, which is within their historical range. But emerging markets equities are trading at around 12 times forward earnings. That lower relative valuation is an argument for the potential opportunities in emerging markets and thus an allocation to them.
The U.S. equity market represents about 55% of the total global market capitalization. By comparison, emerging markets are about 12% of global market cap and they represent approximately 24% of non-U.S. equity investments. That market cap is continuing to move higher over time. A typical balanced portfolio of 60% equities and 40% fixed income would indicate a market-neutral allocation to emerging markets equities of 5% to 6%.
It’s important to note that corporate earnings still are depressed when compared with their levels prior to the global financial recession. There was a tremendous decline in corporate earnings at that time, followed by a sharp recovery among U.S. companies. But outside of the U.S., that earnings recovery is just now starting to play out. Valuations may begin to increase if there is continued earnings growth in foreign developed and especially emerging markets.
Q: What's the role of the U.S. dollar or local currency in making an allocation to emerging markets?
Many investors group emerging market fixed income into one big bucket, but there are two very different types of markets: a local currency rates market and a U.S. dollar-denominated corporate market. Emerging markets offer sovereign government bonds in their local currencies, similar to how the U.S. offers Treasury securities in U.S. dollars. There also is a significant amount of U.S. dollar-denominated corporate issues, mainly because many emerging markets lack capital markets with sufficient depth to provide the financing that companies seek. The key point is that the variation provides two different areas in which to seek diversification, pursue returns and manage risk.
There was a period of U.S. dollar strength during the five years that ended in 2016, so investments in dollar-denominated issues were likely to have outperformed during that time. But we think that is less likely going forward. That opens the potential to look at a variety of alternatives, such as emerging market sovereign debt denominated in the local currency, that type of sovereign debt denominated in U.S. dollars, and emerging market corporate debt in U.S. dollars. While we believe all three can provide opportunities, we have a preference now for the local currency debt.
Q: How can investors use fixed income in a portfolio today? Many have questioned whether returns can match their historical levels.
Given interest rates, we don’t think there is the scope for the type of returns from fixed income that we’ve seen in the past. We think there’s a need to actively manage a fixed income portfolio – simply buying and holding the 10-year U.S. Treasury is not likely to generate the type of return that many investors are seeking, especially those who are pursuing an income goal.
When thinking about asset allocation in a portfolio, we’re looking at fixed income to do different things than seek an equity-like return. We formerly approached asset allocation as a process, but now see it from an outcome orientation. For example, that might mean 60% to 70% of a portfolio is invested in equities to pursue a desired level of return, and then the remainder gets a risk-managed approach as part of pursuing the overall desired outcome.
Q: Fixed income often is seen as a "safe haven" investment, but is that true across all debt securities?
There can be risk in multiple parts of the yield curve, so it’s important to be well diversified across the fixed income spectrum. For example, there is risk now in the shorter-maturity end of the curve from the potential for interest rate hikes by the U.S. Federal Reserve, and there is risk at the longer end of the curve from the potential for inflation picking up. I think that wide range of potential risks in the yield curve argues for both diversification and active management. Within fixed income now, I think it may add risk to follow what might be called a “buy and hold” strategy with longer-term investments. In our view, that approach actually could add risk. Again, we think actively managing fixed income investments, and their risks, is important in the current environment.
Q: What's the role of alternative asset classes in pursuing risk-adjusted returns now?
Most investors have been pushed into a corner of taking either duration risk or credit risk to get additional yield. We think today’s market offers an alternative in illiquid or semi-liquid securities as a way to pursue additional yield. I’d add that many investors get hung up on making a choice: “Should I be in this investment or should I be in that?” Instead, we look for the best relative valuations across the full spectrum of the credit market. We think that approach in the last three to four years has added stability to a portfolio versus selecting distinct asset classes on a one-off basis.
When you are pursuing higher return, there’s a “give up” – you either must take duration risk, credit risk, liquidity risk or leverage risk. Any and all of those can contribute to potential return, but getting a higher return in today’s market cycle is likely to mean taking more risk. And given today’s market, I also believe it makes sense to be diversified, not just across asset classes but across different drivers of risk.
Q: What's the bottom line? Does diversification matter more now because of the changing market environment?
I still believe firmly in diversification, to the extent that it represents investing in assets that are less than perfectly correlated and are expected to generate a positive expected return. Considering the market of the last five years, many investors who were not diversified and instead focused on U.S. equities had outsized returns. The market environment has been dominated by U.S. equities, which outperformed foreign developed, international and emerging markets. I think it’s highly unlikely that situation will persist going forward, so I think it will be important to be diversified when looking at the next five to 10 years.
I would add that we think the key is not diversification just for the sake of diversifying, but also to consider a multi-asset approach. Valuations have been on the move and we think that will continue. Individuals in the past might ask where to “park” fixed income investments for some period of time. In our view, park them but keep the car running because it’s likely that changes in valuations may mean a move to a new spot. Some of these moves happen quickly and could prompt a change in an allocation to a specific asset. That may argue for investors to consider using an active manager of a multi-asset approach, where the allocation decisions can be done by investment professionals who are focused on finding the best relative value at any given time.
Past performance is not a guarantee of future results. Investment return and principal value will fluctuate, and it is possible to lose money by investing. International investing involves additional risks, including currency fluctuations, political or economic conditions affecting the foreign country, and differences in accounting standards and foreign regulations. These risks are magnified in emerging markets. Fixed income securities are subject to interest rate risk and, as such, the net asset value of a fixed income security may fall as interest rates rise. Investing in below investment grade securities may carry a greater risk of nonpayment of interest or principal than higher-rated bonds. These and other risks are more fully described in a fund’s prospectus.
Asset allocation and diversification do not ensure a profit or protect against loss in a declining market. They are methods to manage risk.
The opinions expressed are those of the panel members and are not meant as investment advice or to predict or project the future performance of any investment product. The opinions are current through November 2017, are subject to change at any time based on market and other current conditions, and no forecasts can be guaranteed. This commentary is being provided as a general source of information and is not intended as a recommendation to purchase, sell, or hold any specific security or to engage in any investment strategy. Investment decisions should always be made based on an investor’s specific objectives, financial needs, risk tolerance and time horizon.