It is a well-known fact that 2018 has been characterised by what we term the end of the bond bull cycle. Heading into the earlier trading sessions of 2018 way back in January, we had stated on a number of occasions via various publications that markets, particularly credit, could have been considered to be expensive.
Not only in terms of valuations but also when viewed in the greater scheme of things, particularly the rally the asset class has had since the 2008 crisis, as a result of accommodative central banks. One must realise and appreciate that investment and economic cycles are shorter than they have been in the past. If we had to remove last week’s volatility out of the equation, credit has been weak this year.
Therefore, what should an investor do when the asset classes s/he is familiar with appear overpriced, or rather have begun correction phase? The 10-year US Treasury bond currently yields about 3.2%, significantly lower than the 5% historical average and only slightly higher than the Federal Reserve’s 2% inflation target. Despite the re-pricing in benchmark yields, investors are not compensated (insufficient risk premium) in terms of yield when going for lower-quality bonds when compared with on a like-for-like basis with those of traditionally safe treasuries or bonds.
Investors generally put their money to work with a long investment horizon and thus can benefit from market upswings and downswings. Theory and historical data suggests that no one can consistently time the market, but entry points ultimately determine the return an investor makes on an investment. Market-timing involves making two key decisions—when to buy an investment and when to take profits (or cut losses). Timing both to perfection is almost impossible; not even the most algorithm or experienced investor will get both correct consistently. Investors who attempt to outsmart the market often get it wrong.
The two strategies that work in keeping their investment risks in check and attempt to reduce the dependency on market timing are broad diversification and rebalancing.
Broad diversification is commonly referred to as the most simplistic (yet effective) of ways of reducing market risk. By holding a wide variety of asset classes, investors have, in the past, historically enjoyed smoother gains during bull markets and dampened losses during bear markets. In a diversified portfolio, asset allocation decisions are key, and, more importantly, understanding asset correlation on returns will aid asset managers ascertain that optimal risky portfolio which maximizes the return potential for a given unit of portfolio risk.
Portfolio rebalancing is another technique asset managers use to manage risk. Both the seasoned and inexperienced investor would do well to portfolio allocations periodically to ensure that they have not deviated (through market movements) from desired levels. If for example the weak emerging market credit performance in 2018 resulted in a lower proportion than what had been originally planned out, it would be appropriate for the under exposure to be increased to the desired levels.
Global asset allocation funds are those funds managed by investment professionals whose task it is on a daily basis to continuously challenge their strategic asset allocation decisions whilst striving to achieve that optimal asset allocation through the use of diversification and rebalancing techniques.
Disclaimer: This article was issued by Mark Vella, investment manager at Calamatta Cuschieri. For more information visit, www.cc.com.mt. The information, view and opinions provided in this article are being provided solely for educational and informational purposes and should not be construed as investment advice, advice concerning particular investments or investment decisions, or tax or legal advice.