Return to the future

Markets, policy makers and politics were on the move again over the week. The Fed and the ECB announced important policy steps, while Trump and China kept on hinting they were getting closer to a trade war. Risky assets, especially in emerging markets, were on the back foot again. In line with most of the year so far, global markets are showing more volatility than direction. Despite the fact that the underlying global economy is actually holding up quite well despite all the noise, it has clearly become more challenging than in recent years to bring in attractive investment returns. Returns across asset classes have been mixed and only a few parts of the market have delivered positive returns. In such an environment, and with interest rates still very low by historical comparison, the need to deliver alternative sources of return for investors rather than just searching for yield is increasing.

The good thing about challenges and new developments that are unfolding in our economic system is that change also always creates opportunity. One of the most-discussed changes is the digitalization of our society. This creates new ways of communicating and new ways of living for many. It enables new technology to service us better and faster. It also has created an amazing amount of new data that, in combination with new tools, create a lot of new insights that can be used to make smarter investment decisions. That can help to augment human creativity and thereby improve investors’ forecasting skill. It will never create perfect foresight, but it helps to mitigate biases in decision-making, it allows for faster decision making and it creates a better-informed and more open-minded perspective on what drives markets. As a result, the persistency of investment results is likely to improve.

When thinking about new opportunities and alternative return sources, three other areas currently stand out: illiquidity, responsible investing and behavioural analysis. All these themes can offer new sources of returns if exploited in the right way. The less liquid or non-publicly traded part of financial markets has always offered an additional risk premium to investors for more limited flexibility (selling these assets is not always easy) and less price discovery of market forces, which creates more uncertainty about how to value these assets. Furthermore, inspired by the relatively attractive treatment in insurance and pension regulations and the perception of low pricing volatility – if you hardly trade, prices do not move much – the popularity of private market assets has also increased, both on the equity and on the debt side. Given the very different nature of these assets, and how they are priced and traded, they are not easy to add to one’s portfolio. But with ample demand for these assets and with rising appetite to use this channel as a source of funding for corporates, for infrastructure and real estate companies and for mortgage providers, it is certainly an interesting source of return to consider when looking for alternatives.  

Another increasingly attractive option is to tap into the rapidly rising need in society to put our economic model on a more sustainable path. Both consumers and firms are increasingly aware that we need to invest our time, energy and savings into a sustainable future. And with social and environmental tension rising in many parts of the world, investments in that direction are also starting to have increasingly direct economic benefits as they leverage on a rising demand for solutions in these areas. Therefore, the use of environmental, social and governance (ESG) factors in an investment approach also allows investors to better capture the economic value that arises from the solutions for these sustainability challenges. And it creates a more responsible way of investing where there is not only a financial benefit, but also a broader contribution to society that is eventually delivered. By using our capital market expertise in combination with ESG insights, we actually create incentives for capital users (like corporations) to deploy the investments they make with the capital in a more sustainable way. This is further enhanced by focusing on inclusion and dialogue with the corporate sector we invest in. This, in turn, further improves our insight in ESG trends and the best way to use them in generating returns, and it inspires companies to adapt as they start to see the (economic) benefits of running their business more responsibly. Our research as well as the performance results of our equity, fixed income and multi-asset sustainable strategies also confirm that a responsible investing approach adds value portfolio management perspective.  

Finally, using behavioural insights into investors and into the market as a whole is another increasingly important source of return. The behavioural finance literature and the works of Nobel prize-winning academics like Kahneman, Schiller and Thaler have provided ample evidence of the influence of emotions on decision-making and the non-rational behaviour of individuals and markets as a whole. Based on this and, interestingly, on the insights from “efficient market” guru Eugene Fama, the whole factor investing trend has emerged over the last decade as a way to exploit behavioural premiums in financial markets, first mainly in equity markets, where most of the academic research was focused, but increasingly now also in credit and multi-asset strategies. Next to these factor strategies that mostly use structured financial market data as input for their analysis, new opportunities have emerged in recent years that use less structured Big Data and new AI techniques to identify sentiment factors that drive markets and to allow for faster adaptation to shifting market behaviour in an investment strategy.

These opportunities do not mean it has become easier to deliver returns. The environment we operate in has probably become only more complex and some of the traditional approaches to delivering investment returns have become less effective. Still these approaches continue to have their value, as a thorough understanding of underlying fundamentals in the economy remains indispensable. Moreover, even in a low-yield world, traditional risk premiums will still deliver some value over time. However, if one wants to deliver excellence in future returns, one cannot overlook the new opportunities offered by the illiquid parts of the market, a more responsible investment approach and a deeper understanding of the benefits of behavioural analysis. That way investment returns will have a better future.

More views on macroeconomics and asset allocation? Follow me on Twitter: @ValentijnvN