Over the past few years, investors have exhibited a strong appetite for risk, particularly inclined toward equities and higher-risk corners of the fixed-income market. But as signals of a late-stage bull market and a possible recession become harder to dismiss, it may be time to re-introduce some ballast into portfolios — even if it comes with a little pain.
In a recent piece published by the CFA Institute, Joachim Klement, CFA and trustee of the CFA Institute Research Foundation, made reference to the “bezzle,” “inventory of undiscovered embezzlements” that swells in times of rising markets, leading to large losses for investors once they are exposed.
“The bezzle of the current bull market isn’t stocked with Ponzi schemes and outright frauds in my view,” he wrote. “Rather it is built on the notion that risky assets have become practically risk-free thanks to central bank policies. “
That view, Klement argued, emerged with near-zero interest rates that were ushered in by central banks. Since then, investors have been advised to hunt for yield and take on more risk in their portfolios: from that came a TINA (“there is no alternative” to stocks”) mindset, along with a widespread hunt for higher yield in fixed income, as well as a wholesale use of low-volatility and high-dividend stocks to substitute for bonds.
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“No wonder low-volatility stocks have outperformed the global equity market over the last decade,” he said, referring to the performance of the MSCI World Index against the HFR Low Vol Risk Premium Index over the 10 years that ended in July this year.
He spoke out against the oft-quoted aphorism, “The biggest risk is not taking any risk,” attributed to Mark Zuckerberg and used by some investment strategists. While he agreed that risk is necessary, it does not negate the possibility of failure or catastrophe in the event that a risk materializes.
As an example, he shared his experience with a family office client whose portfolio he was asked to optimize. A third of the portfolio had been invested in property, a third in shares of the founder’s company, and a third in liquid assets. Since the family office was based in Switzerland, most government bonds it had access to came with negative yields; property or stock-market investments were not an option as they were already present in high concentrations within the portfolio.
“[T]he client had to choose between taking on duration, credit, or foreign exchange risk — or some combination of them — in fixed-income investments,” Klement said, noting that the client opted for a combination of credit and duration risk.
While the strategy has reportedly worked out well so far, thanks in part to ample liquidity provided by central banks, there’s still the possibility of the risks hurting the portfolio in the face of a recession. “[M]y guess is that credit and equity market risks will play a role,” he said.
Urging a review of risks in portfolios, he reminded investors to stick to risks that they can live with. Any risks that go beyond that must be reduced or hedged, he said, with government bonds — even at negative yields — cash, or other safe assets.
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