Midyear Outlook: Portfolio allocation after COVID-19
Last week, when we announced the publication of our midyear outlook, we suggested that investors face powerful crosscurrents for the remainder of the year. On one hand, fiscal and monetary policy efforts have stifled the worst-case COVID-19-related scenarios. At the same time, widespread business closures, job losses, and behavioral shifts portend sustained and painful demand destruction.
Policy support seems adequate to sustain high valuations – at least for now. But what forces will guide the market narrative on the other side of the crisis?
High volatility means portfolio adjustments will be acutely felt
Both significant levels of uncertainty and volatility have important implications for asset allocation and portfolio construction. In periods of high market volatility, unstable correlations and fitful factor leadership can lead to unintended risk exposure. This means even a small tactical change can have an outsized impact on portfolio performance.
That doesn’t mean investors should avoid any changes to their portfolios; tactical positions have the potential to enhance long-term returns. However, it should not dominate a long-term strategic risk allocation.
We encourage investors to stay true to their goals, maintain portfolio risk levels close to their benchmark risk, carefully consider factor divalersification, and take hedges seriously.
For every shape of the recovery there is an optimal tactical positioning.
Acknowledging that uncertainty clouds the investment environment, we believe there is an optimal tactical allocation for any view of the path forward. Investors should root their positioning in their own risk tolerance and investment goals. From there, we illustrated potential tactical allocation ideas with three hypothetical portfolios.
- Our V-shaped portfolio illustrates an appropriate path for investors expecting the economy to continue its sharp recovery, and corporate profits to follow.
- Our L-shaped portfolio assumes that credit and equity markets are not pricing the substantial risk that company earnings face and are likely to re-rate significantly.
- Finally, our K-shaped portfolio grants that policy support to date allows asset prices to bridge the economic gap created by COVID-19, but not without significant disruption. In this case, we expect valuation stagnation in the months (and perhaps years) ahead.
We expand on our views and the following portfolio construction ideas in our Midyear Outlook.
Why these allocations?
In periods of high quality, any deviation from an investor’s strategic benchmark will be acutely felt. As a result, we limited all tactical portfolio changes to one-fifth of total strategic risk. In practice, this is roughly a one to two percent tracking error relative to a portfolio’s benchmark. For investors who believe that volatility will be subdued, more aggressive tactical allocations may be warranted.
Our instinct is to remain conservative in our investment policy. Despite a global recession, we have yet to witness the hallmark attributes that entice us to take a meaningful overweight in risk assets. Consumer and corporate debt levels have increased, financial assets have become more expensive, and the creative destruction that normally accompanies an economic downturn has been delayed — at least so far.
For now, potential upside drivers are limited, while downside risks are considerable and often ignored. Structurally, we anticipate a reduced appetite to increase leverage, more conservative use of capital, and lower returns on equity going forward.
Admittedly, much remains uncertain. These structural factors only increase our conviction in active management during times of heavy uncertainty. We believe strongly in prioritizing wise investing over the maximization of short-term returns. Risk control and consistency are of utmost importance to helping our partners achieve their financial goals.
This material represents an assessment of the market environment as at a specific date; is subject to change; and is not intended to be a forecast of future events or a guarantee of future results. This information should not be relied upon by the reader as research or investment advice regarding any funds or any particular issuer/security. The strategies discussed are strictly for illustrative and educational purposes and are not a recommendation, offer or solicitation to buy or sell any securities or to adopt any investment strategy. There is no guarantee that any strategies discussed will be effective.
Any forward-looking statements are based on a number of assumptions concerning future events and although we believe the sources used are reliable, the information contained in these materials has not been independently verified and its accuracy is not guaranteed. In addition, there is no guarantee that market expectations will be achieved.
This material contains general information only and does not take into account an individual’s financial circumstances. This information should not be relied upon as a primary basis for an investment decision. Rather, an assessment should be made as to whether the information is appropriate in individual circumstances and consideration should be given to talking to a financial advisor before making an investment decision.
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