his article first appeared in FTfm, the Financial Times’ fund management supplement, on April 8, 2013.
Like all Fed chairmen, Ben Bernanke keeps a good poker face. But privately, like millions of investors, he must be elated with the stock market’s rally to record highs. The Fed’s policies, after all, were intended to boost asset prices, revive risk appetites and stimulate the wealth effect – all in the hope of generating a self-sustaining economic recovery.
Yet even if this occurs – and PIMCO hopes it does – the major developed economies will continue to face headwinds that will stunt longer term financial market returns for years to come. Swelling debt, tightening regulation and aging populations will continue to drive the New Normal, the macroeconomic dynamic we labeled in May 2009, which anticipates a prolonged period of subpar growth.
Increasingly, these trends will drive investors to nontraditional and highly active strategies with potential for incremental alpha and returns uncorrelated with traditional stocks and bonds. New sources of diversifying financial betas, including currency, commodity and volatility, will grow more common in portfolios. Strategies dependent on high degrees of manager discretion, such as market-neutral and long/short equity, will aid diversification and offer potential downside-risk mitigation.
To compete, investment managers will need to help investors think alternatively about risk and reward objectives. Managers will need deeper and more diverse talent, global presence and a flexible yet intellectually rigorous process of analysis and decision-making. They also will have to offer alternative strategies in mutual funds and other liquid structures that an array of institutional and individual investors can easily access.
Hyper-stimulative monetary policies in the U.S. and elsewhere have helped the Dow Jones Industrial Average double over the past four years, yet it is unclear whether job creation and economic growth will take off. Hence, investors should consider how a sustained period of historically low growth would affect the math of security valuation.
Distilled down to basics, financial prices are a function of terminal values of an asset at a specified future date, cash flows and discount rates. The market value of every security ultimately reflects the future cash flows investors expect the underlying asset or enterprise to generate. These flows, coupled with an expected terminal value, are then discounted at a risk-adjusted rate to determine their present value.
Amid low growth, however, the scope for inflation-adjusted terminal values and cash flows to surprise on the upside would be limited. Today’s exceptionally low interest, and hence discount, rates have already increased the present value of expected cash flows. Thus, the outlook suggests that returns from financial betas – indeed, all betas across all asset classes – will likely remain below their historical norms for a lengthy period.
This admittedly sober outlook explains why “liquid alternatives” has become the latest investment buzzword. Broadly, PIMCO defines these as highly active investment strategies exposed to non-traditional betas that are uncorrelated to traditional stock and bond returns; unconstrained by benchmarks, they may use shorting and other tactical approaches to risk factor exposures, sometimes with the explicit intent to limit downside risk.
Importantly, liquid alternatives can be bought and sold as mutual funds, making them accessible to a broad range of investors who would generally not have access to, or an appetite for, the traditional private alternatives marketplace.
Survival of the fittest
As investors migrate to liquid alternatives, demand may fall for active managers who add little value, such as closet indexers. Investors will quickly discern and discriminate among those who simply “talk the talk” and those who can “walk the walk.”
To compete in an era of historically low financial market returns, asset managers will be required to demonstrate strengths in the following areas:
- Global reach. Superior return opportunities will not be localized to one market or geography.
- Investment process. Managers will need to demonstrate intellectually rigorous analysis and decision-making.
- Flexibility. Managers will need to rethink traditional asset class definitions and reconceptualize boundaries of risk and return.
- Risk management. Liquid alternatives demand a rigorous and focused approach to risk management, which may include embedded discrete tail-risk hedging strategies.
In an era of low beta returns, active managers that can produce consistent, high quality, liquid and diversifying returns in easily accessed structures will be best able to help investors achieve their goals. It’s time to think alternatively.