Q: What do you mean by “solutions” as referenced in your title and domain of responsibility?
A: We use that word to refer to investment strategies whose success and risk are defined in an outcome-oriented way as opposed to a benchmark-oriented way. For example, a traditional investment strategy might define success as beating a particular index. With a solutions-oriented strategy, we would define success as providing an income for life or paying for a child's college education. We might define risk in a traditional product as tracking error, while a solutions-oriented strategy might define risk as losing money or failing to meet your goals. So it's purpose-driven as opposed to benchmark-driven. To put a finer point on it, we have brought a number of capabilities that map to those purpose-driven investments into one overall investment organization which I lead. These include asset allocation, alternative investments, multi-manager strategies, structured equity strategies and liability-driven investing.
Q: With the U.S. stock market having risen for six consecutive years and bond yields recently moving lower once again, how do you see things unfolding this year?
A: The post crisis environment has been great for investors. The S&P 500 has tripled since its low marks in early 2009. Bonds have also done very well as yields have dropped and spreads have tightened. It has been a good time to be invested and to be taking market risk, and we think that trend will continue in 2015. However, the very fact that markets have done so well comes somewhat at the expense of future expected returns, particularly for bonds. So we expect the trajectory of returns to begin to moderate this year.
As 2015 begins, equities retain a very important valuation advantage compared with bonds. 2014 showed how important this can be to relative returns. Last year, most investors expected interest rates to rise or at least to stay where they were. Instead interest rates fell, so investors made more money from bonds than they expected. Stocks on the other hand somewhat disappointed, with the return from global equities actually lagging the change in EPS growth. But even though bonds gave an upside surprise and stocks gave a downside surprise, stocks still outperformed bonds on a worldwide basis. I think that highlights one of the key features of today's landscape: Prospectively, there is a real valuation advantage for equities in terms of their expected returns versus bonds.
Q: In your 2015 market outlook, you wrote, “While valuation strongly suggests an equity-dominated portfolio strategy, a portfolio concentrated in risk assets remains vulnerable to volatility spikes” and that “diversification alone may be inadequate to protect portfolio values from future drawdowns.” What do you mean by this?
A: I believe the relative value landscape encourages investors to focus on opportunities in global equities for the return seeking part of their portfolio. With zero interest rates and quantitative easing, central banks are providing the motivation for risk taking, and I think there is scope for further gains from stock markets. However, investors this deep into a recovery need to also think about strategies to preserve those accumulated gains. How do we continue to take risk, but not put so much of our gains that have accrued over the last six years at risk? The first line of defense is making sure that not all of our eggs are in the same basket. But with so many financial markets tied together by the common influence of interventionist policies, I worry that we might be overconfident in the ability of traditional diversification to stabilize our returns. We have actually seen some shots across the bow in that respect, e.g., the taper tantrum, last fall’s volatility storm and the December drawdown. Each of these episodes was a profile of simultaneous drawdown across the asset classes. I am concerned that this defines today’s risk management challenge. If we can't depend upon traditional diversification to stabilize our portfolios and insulate against “giving it back”, what can we do? First, I think we have to dig a little bit deeper into modern strategies to find ways to expand our pallet of diversifiers. Are there other things we can bring into our portfolio that can make diversification stronger than if we had only built it out of traditional building blocks? Second, I believe we need to equip ourselves for active and deliberate de-risking under certain conditions. Instead of being caught like a deer in the headlights if diversification fails us, we need a mechanism to enable purposeful allocation shifts designed to make our portfolios more stable, more resilient and more durable in the face of a volatility storm.
Q: How would you suggest investors think about an investment strategy in the current landscape?
A: We have talked about one key aspect of this investment landscape — the relative value advantage of equities over bonds. In order to devise a prudent investment strategy, I think we need to incorporate another key element of today's investment landscape — the asynchronous nature of monetary policy. Over the past three or four years, we've had near unanimity of central bank policy. This year, however, the U.S. Fed is very likely to start raising rates, while other central banks like the European Central Bank and the Bank of Japan are continuing on a full force easing campaign. That difference creates pressure for a stronger U.S. dollar which can have a negative effect on risk assets. We see financial conditions easing where currencies are weakening (Europe and Japan) in a way that adds to the monetary stimulus and provides a tailwind to economic activity and market returns. On the other hand, it becomes something of a headwind where currencies are strengthening (U.S.). So my return-seeking investment strategy for 2015 would be much more global in scope. Importantly, we think that investments denominated in foreign currencies should include a strategy to hedge that currency risk, as we expect further appreciation in the U.S. dollar. Furthermore, in order for that strategy to adapt to changing market conditions, it needs three additional components:
- Non-traditional diversifiers, such as liquid alternatives, alternative beta exposures and absolute return strategies
- Explicit downside hedges, such as put options (with emphasis on managing the related expense)
- Flexibility and a methodology for active risk reduction when appropriate
In summary, I believe we are still going through a process that is flattering to financial market returns. But after six years and a tripling of the stock market, recognize that we're getting late in the game. Does Europe hang together? Do events in the Ukraine or Greece disrupt the economic recovery in Europe? Is the Fed’s tightening appropriate, or does it represent a threat to financial markets? Will those who come out on the short end of oil’s dramatic repricing emerge as a threat to capital markets either through default and bankruptcies, or worse through geopolitical tensions? These risks are out there and we need to think about them. While I don't think it's time to bail on taking investment risk by any stretch, I do think that the time investors spend thinking about ways to protect the hard-fought gains of the last six years will be time well spent in 2015.
The views expressed are as of 3/9/15, may change as market or other conditions change, and may differ from views expressed by other Columbia Management Investment Advisers, LLC (CMIA) associates or affiliates. Actual investments or investment decisions made by CMIA and its affiliates, whether for its own account or on behalf of clients, will not necessarily reflect the views expressed. This information is not intended to provide investment advice and does not account for individual investor circumstances. Investment decisions should always be made based on an investor's specific financial needs, objectives, goals, time horizon, and risk tolerance. Asset classes described may not be suitable for all investors. Past performance does not guarantee future results and no forecast should be considered a guarantee either. Since economic and market conditions change frequently, there can be no assurance that the trends described here will continue or that the forecasts are accurate.
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