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4 Portfolio Strategies for When ‘Nirvana Period of Free Lunch’ Ends

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A balanced portfolio that once saw double-digit returns likely won’t when the Federal Reserve tightens and normalizes monetary policy.

In the past six and a half years, investors have experienced what Lisa Shalett, head of investment & portfolio strategies for Morgan Stanley Wealth Management, calls “this nirvana period of free lunch.”

“Over the last six and half years, the S&P 500 has compounded at roughly 15% [and] at the same time the U.S. bond market has compounded at 9%,” she explained during a press briefing last week in New York. “Now typically stocks and bonds are negatively correlated, right? One of the outgrowths of quantitative easing is that they were positively correlated. So if you had a balanced portfolio of stocks and bonds, you experienced superior returns, and that portfolio has returned double digits.”

The Fed resisted moving at its last meeting, but what happens when policy begins to normalize and when the Fed in fact begins to tighten?

“Our outlook is that the balanced portfolio that delivered those double-digit returns probably over the next 5-7 years is going to return something a lot closer to 4%-6%,” Shalett said, adding, “those 4-6% returns are pretty decent. They’re OK, but they’re not going to be the double digits that we’ve seen over the past six years.”

Shalett shared the advice she’s currently giving wealth management clients on how to position their portfolios in preparation of the Fed tightening policy:

Globalize Portfolios

1. Globalize Portfolios

“The first piece of advice that we press hard on is this idea of globalizing your portfolios,” Shalett said.

This can be a challenge for clients, who tend to be U.S. citizens and have a U.S. bias.

“One of the challenges that we have … is opening their mind to the opportunities,” she said, including “places like Europe and places like Japan, in addition to the United States.”

Manage Volatility With Alts

2. Manage Volatility With Alts

Because quantitative easing and zero interest rates caused overall volatility in markets to come down, Shalett said that it’s going to feel “way more volatile” as policy begins to readjust.

“Now is the time to rethink ‘How do you manage volatility?’” Shalett said. “Now historically – certainly prior to the crisis – one way you managed volatility was with bonds [and] they will continue to play that role.”

But, she added, the problem with using bonds is that the Fed has a tightening bias.

“And when you have a tightening bias, it means you could have capital loss in those bonds. So what other ways can you manage risk?” she said.

This is where alternative investments come into play.

“Another way that the industry and portfolio constructors and asset allocators have tried to manage risk is by using alternative investments,” Shalett said. Adding, “We are emphasizing using various alternative strategies to help us manage risk and portfolios. Those alternative strategies include hedged strategies – so, equity long-short type strategies, global macro-type strategies, credit long-short type strategies and event-driven strategies.”

This may take some convincing, as the low volatility has cause a lot of alts to disappoint investors.

“[Alts] need volatility to demonstrate their value proposition,” Shalett said. “That value proposition is very much in question right now. One of the challenges we have is convincing our clients that just at the moment when it looks like this particular asset class may have lost efficacy is exactly the time you need it because it will have efficacy.”

Don’t give up on active management

3. Don’t give up on active management

“Another anomaly of this cycle, over the past six and a half years, has been the dominance and outperformance of passive strategies,” Shalett said. “Why? Because quantitative easing took the rising tide and lifted all the boats. The vast majority of the expansion this cycle was all about beta, was all about inflating assets. There wasn’t a lot of dispersion in markets.”

Shalett is urging clients not to give up on active management.

“This is the exact point where people have almost given up on active, that it’s highly likely that active management is going to work and add value,” she said. “And, in fact, in August – this latest sell-off – was the first time in a really long time that we saw active managers outperform in a big way. We want a lot of our advice to rebalance this bias our clients have taken towards passive and come back to active because we think that active management can also outperform.”

Focus on finding secular growth

4. Focus on finding secular growth

“In this world of lower for longer, lower growth, lower rates, you really have to focus on finding secular growth,” Shalett said.

According to Shalett, stocks that are showing secular growth include the “biotech stocks, the social media stocks, a smaller and smaller group of stocks.”

“From our perspective, that group of secular growth stocks, while they are expensive, may in fact still have ‘room to run,’” she said. “So despite their valuations, we’re continuing to tell our clients to have some exposure to those stocks because in a growth-starved world we think they are going to continue to be big. But you probably want to barbell those with some of the stocks that have gotten punished in this overall sell-off.”

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