Consultants advise diversification as recession fears mount

Rich Nuzum, global chief investment strategist at Mercer, says: “I’m sure there will be both positive and negative shocks [this year] that we’re not anticipating [at the moment], but right now our outlook for global capital markets in 2023 would be pretty benign.”

However, citing a wage-price spiral and the fallout from Russia’s invasion of Ukraine as two “shocks” that policymakers globally are grappling with, he adds: “One of the big mysteries is why market expectations of near-term volatility [are] so low when there’s such huge uncertainty about which tail we’ll be into two to three years out.

“Could we have deflation instead of inflation? Do we get a favourable resolution to the war in Ukraine or not?”

One of the big mysteries is why market expectations of near-term volatility are so low when there’s such huge uncertainty about which tail we’ll be into two to three years out

Rich Nuzum, Mercer

Portfolio resilience

Given the uncertainty surrounding the outcomes of these issues, Nuzum says institutional clients are advised to review their risk budgeting and asset allocation to ensure their portfolios are able to withstand a tail event.

He also points to the importance of having the governance capability to respond to “extreme shocks” and the investment opportunities they may present in “an agile way”.

Institutional clients are therefore advised, where feasible, to adopt a dynamic asset allocation or tactical asset allocation approach to investing.

Smaller, governance-constrained asset owners might choose to delegate the dynamic management of their portfolio to an outsourced chief investment officer, Nuzum says.

Another approach to nimble investing that “sophisticated” asset owners are moving towards, particularly in the wake of the UK’s liability-driven investment crisis, is to have a synthetic equity component to their portfolio.

“[For example,] instead of investing in a passive index fund, investors [could] hold cash plus equity futures or cash plus swaps,” Nuzum says.

“So, when something happens amid extreme prices with low liquidity – it could be margin calls, it could be the need to make benefit payments, it could be capital calls on their existing private markets portfolio – they don’t have to sell anything in the physical market. They’ve actually got cash sitting there that they can deploy.” 

Private markets

Nuzum points to strong, ongoing demand for private market investments, particularly private equity, private debt, real estate and infrastructure, as institutional clients look to reap extra returns and diversification benefits.

“For instance, our most sophisticated sovereign wealth fund clients are overweight venture capital and early-stage growth strategies; first, for the return and diversification potential, and second, [due to] a strong belief that that’s where innovation happens,” he says.

David Rae, head of strategic client solutions at Russell Investments, tells Pensions Expert’s sister title MandateWire that institutional clients are advised toimplement some form of downside protection in their portfolios.

“We see institutional investors continuing to diversify their portfolios, whether across or within asset classes,” he says.

He adds that in a bid to generate more return in volatile markets, institutional clients have also added an element of active management, such as dynamic asset allocation, or individual security selection within asset classes, or by investing in certain hedge fund strategies.

Regarding the use of equity options to manage tail risk, Rae says there was increased interest among institutional clients in purchasing options when equity markets were performing well last year.

Now, with increased market volatility having driven up the price of equity options, asset owners are employing instead the “first techniques” of portfolio diversification and active management.

Rae highlights “attractive opportunities” to invest in credit on the back of widening spreads. However, he says investors face the challenge of determining “to what extent the weak economic outlook might feed into an increased default probability, and [whether] credit instruments still look valuable given that default probability”.

When it comes to investing in private markets, he says asset owners should consider the “valuation opportunities” in private equity, infrastructure and private debt over a one to two-year time horizon.

“It takes time to put money to work [in those asset classes]. If we go through a market shock, the pricing of those assets might be more attractive over the coming years and so we’re thinking about the potential attractiveness of future vintages in some of those private market assets and how you allocate to them today rather than [later],” he says.

LDI concerns

Alasdair Macdonald, chief investment officer of UK investment advisory at WTW, tells MandateWire that for UK corporate defined benefit pension schemes, which generally pursue relatively low-risk investment strategies, the market outlook is “probably less important” than the outlook for long-term UK interest rates and liability hedging in the aftermath of the gilt market turmoil last September.

“In the short term, UK DB pension funds need to get comfortable with where they find themselves given the extreme market moves [seen last year],” he says.

While that review might prompt pension schemes to make some changes to their portfolio, Macdonald says schemes are advised against making significant strategic changes until “we get more certainty around what the new world looks like for liability hedging. And we just don’t really have clarity on that”.

This article originally appeared on MandateWire.com