In a previous blog I discussed the many ways in which the investment climate has changed, and why we’re unlikely to revert back to a more familiar environment anytime soon.
Given the magnitude and scope of these changes, it is natural that many investors have decided to deal with the uncertainty by simply increasing their allocation to cash. While this may make sense from a tactical perspective, a permanently high cash balance may not be a good long-term solution. With cash yields at zero there are alternatives which increase the potential for yield for investors willing to assume additional risk. Here are three strategies for investors looking to adapt to the new landscape.
1. Cast a wider net
In a low-yield environment, casting a wider net – both geographically and by asset class – may lead to other sources of potential income. Investors looking for higher yields and willing to tolerate additional volatility may consider the judicious use of equity income as a substitute for fixed income. Equity yields currently compare favorably with bonds, and certainly much more favorably than cash. In many parts of the world – Europe, south-east Asia, and select emerging markets – there is still potential to see a 3.5, 4, or even 5% yield at a reasonable valuation with varying degrees of risk.
2. Manage volatility
The global deleveraging is still in its early stages. To the extent this process is contributing to the rise in equity volatility, we may have to contend with turbulent equity markets for a while. That said, abandoning equities entirely is rarely a good idea, as the asset class has historically produced higher returns – both on a nominal and an inflation-adjusted basis – than bonds. An alternative strategy is to consider the use of non-traditional portfolio construction techniques and instruments. In particular, there is strong evidence that minimum volatility portfolios can potentially help investors cushion their portfolios during periods of heightened turbulence, but more importantly can help improve risk adjusted returns over the long-term.
3. Consider commodities
While I do not view inflation as a near-term threat, central bank balance sheets have exploded and there is lingering uncertainty over the US fiscal position; both raise the long-term risk of a potentially significant dollar decline and/or higher inflation. In addition to equities, investors might also consider allocating a small portion of their portfolios to commodities and gold. Physical assets behave differently than paper assets like stocks and bonds. Gold, in particular, has historically been used as a long-term hedge against a loss in purchasing power. For investors with a moderate risk-tolerance that are concerned about inflation, a small, diversified commodity allocation plus another small allocation to gold is reasonable.
In the end, an investor’s asset allocation will be as much a function of their investment goals and risk appetite as the investment landscape. But in an environment in which the macro-conditions are very different from the past twenty-five years, all investors should be re-visiting their investment process and tool-kit. These are different times; most investors will benefit from adjusting their approach.
Disclaimer: Bonds and bond funds will decrease in value as interest rates rise. Bond funds are subject to credit risk, which refers to the possibility that the debt issuers may not be able to make principal and interest payments or may have their debt downgraded by ratings agencies.
In addition to the normal risks associated with investing, international investments may involve risk of capital loss from unfavorable fluctuation in currency values, from differences in generally accepted accounting principles or from economic or political instability in other nations. Emerging markets involve heightened risks related to the same factors as well as increased volatility and lower trading volume.
Minimum volatility funds may experience more than minimum volatility as there is no guarantee that the underlying index’s strategy of seeking to lower volatility will be successful.
Gold and other precious metal prices may be highly volatile. The production and sale of precious metals by governments, central banks or other larger holders can be affected by various economic, financial, social and political factors, which may be unpredictable and may have a significant impact on the supply and prices of precious metals.