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May 04, 2010 at 08:00 PM
More than ever, financial advisors are pondering where to allocate client capital in today’s market environment. The reason? It is difficult to make a distinct case that any one asset class is positioned to break out with above average returns over the next market cycle. Equities are largely believed to be overpriced with expected returns unimpressive after accounting for low current yields, inflationary pressures, and questionable prospects for long-term corporate profit growth. Meanwhile, investment grade fixed income is hovering just above ground with near-zero real return yields, and high yield bonds have literally closed the spread gap after last year’s rally. With the easy money off the table, we seem to be entering an environment of flat single-digit returns in nearly all asset classes.
There are still small opportunities between market segments on a relative basis; however, it is when market returns are muted that specific manager tactics can have a more meaningful impact on performance results. As such, advisors should consider increasing the degree of active management within the market segments or consider non-traditional, alpha-oriented strategies. In areas where the “beta play” seems to be over, and for investors that use benchmark hugging managers, it will be difficult to combat the full brunt of these market headwinds.
Metaphorically, this change in portfolio construction strategy is analogous to trading in one’s paint roller for a cutting brush. Specifically, it is finding managers that dig into security and deal-level alpha and finding those that are navigating the still-inefficient pockets of picked over markets.
There is a distinct art to implementing capital market assumptions, specifically around understanding where direct beta exposure is desired and where a manager’s hands should be unconstrained. In 2010, a desirable implementation strategy may include managers who are security-pickers, who have more latitude across a company’s capital structure, and who seek absolute return. In this environment considerations should be given to long tenured teams with a history of adding value through security selection in potentially illiquid and opaque markets, and the latitude to do so.
