Managers get cautious as tail risks grow

A number of money managers are taking risk off the table across portfolios, moving to a more cautious approach to investment and focusing on capital preservation as tail risks begin to rise.

Some also are choosing to avoid assets that are being supported by central banks' extensive monetary policy actions.

Pacific Investment Management Co. expects to focus on capital preservation and to have more cautious positioning in portfolios over the next three to five years, said Andrew Balls, chief investment officer-global fixed income, in London. He highlighted negative fixed-income yields in Europe and Japan, but there is “an asymmetrical risk that yields will rise over time, so we want to be attuned to that. And medium term we want to avoid negative yields.”

PIMCO's latest secular outlook concludes that tail risks are rising. The $1.5 trillion money manager believes that, in the absence of structural reforms, central bank policies are approaching their limits. Political uncertainty is rising, and unsustainable debt levels mean long-term risks of capital impairment or inflation are also rising.

The firm's medium-term approach is similar to pre-2008, but is different from “a few years ago as valuations have become more stretched,” negative risks have “probably increased, and the ability of central banks to drive asset prices (has) probably diminished.” This adds up to “a more cautious stance” for executives. The manager is particularly cautious on the eurozone, having previously been more positive and overweight sovereign assets in the region. But rising populist political parties and the “perfectly plausible” scenario of eurozone governments completing bail-ins to address excessive leverage have made executives more cautious. Mr. Balls said that in traditional strategies, PIMCO wants to avoid “higher risk, less liquid” assets.

J.P. Morgan Asset Management's Talib Sheikh, multiasset solutions portfolio manager in London, said he has got a “reasonable amount of sympathy” for advocating caution in portfolios. At the $1.7 trillion money manager's recent strategy meeting, the conclusion was “to reduce some risk” across portfolios because there are fewer compelling reasons to maintain exposure to market beta, he said.

The firm is “struggling to find really compelling, value-driven ideas,” and executives have decided to be “fairly neutral on directional risk” in portfolios, he said.

“A lot of things have to go right for things to go well,” said Mr. Sheikh. Inflation would need to move up a bit, but not too far; the U.S. Federal Reserve would need to move interest rates, but not too high.

Colin Harte, portfolio manager and strategist within the multiasset solutions team at BNP Paribas Investment Partners in London, said he also sympathizes with a more cautious approach. The e530 billion ($588.9 billion) money manager is more cautious about fixed interest in the medium term. At the end of last year and start of this year, executives moved to an underweight duration on a number of multiasset funds with a heavy fixed-income bias.

“We would be in the camp that from a fixed (income) perspective we are starting to be a bit more defensive and cautious,” and there are potential risks on the downside, said Mr. Harte.

Matthias Scheiber, fund manager in Schroders PLC's multiasset investment team, said the £324.9 billion ($474.9 billion) money manager's multiasset team has taken a cautious approach “for a while.” He said increased tail risks are “definitely a threat going forward, as all different assets have become influenced by low interest rates either directly ... or indirectly” and keeping interest rates “artificially low boosts asset prices across asset classes. This introduces a potential tail risk at some point if the liquidity is withdrawn,” said Mr. Scheiber. He said a multiasset portfolio needs to be balanced to cope with those risks, having some growth assets, inflation protection — which executives need to “carefully scale” as it costs to take on this hedge — and some bonds, although not too many as returns are limited.

Suzanne Hutchins, London-based manager of The Dreyfus Corp.'s global real return strategy, said the return-seeking core of the fund is around 28%, net of equity index protection, “which is close to the historic low for the strategy as a whole. That core is surrounded by a significant layer of stabilizing assets, including highly liquid government bonds, gold and cash. The era of extraordinary central bank action is far from over and we believe related concerns will continue to make holding an element of our clients' assets in gold worthwhile,” she said. Government bond holdings are 31%, gold is 10% and there is a 5% allocation to cash.

Some money managers are also taking a cautious approach to assets with prices that have been artificially boosted by central bank monetary policy action, such as quantitative easing and asset purchase programs.

Rather than “positioning around this central bank reaction function, rather than surfing the wave, we think we need to take a more cautious approach,” said PIMCO's Mr. Balls. The money manager's response is to avoid or underweight assets that primarily rely on central banks to support their valuations.

Owen Murfin, co-lead manager in London for BlackRock Inc.'s global bond strategies, said: “Some bonds we are reluctant to buy — most are government related.” The U.K.'s bond market is “quite expensive at the moment ... partly due to” the risk of a U.K. exit from the European Union. A referendum on the topic will take place June 23.

“But the expectation at the Bank of England is very benign — it wouldn't take much improvement in U.K. data from here for the BoE to follow the Fed more closely,” Mr. Murfin said. However, he added: “I would avoid bonds that have been manipulated by central bank buying, and (those in asset) bubbles, and (instead) focus on quality income.”

Dreyfus' Ms. Hutchins added: “A significant misallocation of capital, caused by unprecedented cheap debt financing, has created an abundance of "stuff.' Combined with weak demand, this puts pressure on prices, with profits generally falling faster than share prices. Consequently, risk assets are increasingly left without valuation support, with the "support' they are receiving from substantive policy intervention unlikely to last indefinitely.”

But opportunities remain. “I feel that nobody is running lots of risk at the moment, but I feel that there are opportunities to add value in fixed income,” said Mr. Murfin. Investors need to look to credit for these opportunities, he said.

Ms. Hutchins said Dreyfus executives believe episodes of volatility are “increasingly likely. ... Therefore, we maintain a more cautious stance, while using the volatility in markets to add to specific securities when price opportunities arise.”

And Philip Saunders, co-head of Investec Asset Management's multiasset team in London, said he has a contrarian view right now, and that investors already are defensively positioned. “We have been adding exposure in equities but also in credit, and this is counterbalanced by positions in long-dated bonds,” he said.

Similarly, David Zahn, head of European fixed income at Franklin Templeton Investments in London, said the firm is optimistic on the markets. “We definitely think there is more scope for central bank policy to work, especially in Europe,” particularly with the European Central Bank's move to add corporate bonds to its asset purchase program, effective last week. “There is scope for European bonds and credit to do well,” he said. n