PARTNER INSIGHT: Andrew Cole, Head of Multi Asset London at Pictet Asset Management, discusses the challenges of a low yield environment and why leverage has risen in the corporate sector
Experience tells us that targeting income prohibits you from making the asset allocation changes you need to make, particularly at times of stress when you're looking for capital values. We want flexibility so our minimum weighting in all assets is zero. If we don't like something, we don't own it because we want to defend capital at times of stress. This is why we don't target income. Instead our whole philosophy and process is to identify a total return structure.
Diversification
Getting effective diversification has become more challenging. Government bonds and equities used to give you a better risk return profile but in many areas of the world bonds
don't trade, yields are negative in real terms and they don't give you any diversification. So why would you hold them, because all you're doing is getting the riskiness of equities without any offset from government bonds?
That doesn't mean we don't own some bonds. We hold them where we think there's value attached and indeed where we think we can get some capital appreciation. But we try to be smart about it. Our first task is to think about the returns, and our second task is to think about risk management and how we can build a better risk-adjusted portfolio.
One thing that worries us, however, is that leverage has risen a lot in the cycle, particularly in the corporate sector. So when portfolios largely consist of either corporate debt or corporate equities, many of those constituent companies will be highly leveraged, and investors who seek income typically go to the companies that pay high dividends. In turn, companies that pay high dividends tend to have more stable earnings profiles.
These are what we call ‘defensive' companies. Now over the last investment cycle, in order to pay out dividends, those companies borrowed a lot of money. So what might seem to be a company with a stable earnings profile is now highly leveraged. In a slowing growth environment they look stable but as interest rates rise, those are the riskier companies.
Click here to learn more about Pictet's multi-asset approach and why choosing the right sectors is key to maximising investment returns
