Raising resilience in strategic portfolios

Jean Boivin |Sep 23, 2019

We believe it’s imperative to explicitly recognize the uncertainty inherent in return estimates when building resilient portfolios. Here’s what insurers should consider.

Lower-for-longer, again…

Since the global financial crisis, investors have slowly adjusted to a lower-for-longer environment for interest rates. This adjustment is particularly challenging for insurers given the need to meet both liabilities and capital requirements. Within these constraints, insurers are exploring new ways of meeting their goals, whether it is expanding their fixed income toolkit or integrating alternatives into their portfolio as evidenced by the results of this year’s Global Insurance Report. The recent further leg-down in government bond yields and a return to central bank easing have exacerbated the challenge they face.

Fundamental questions need some answers first: Do these renewed yield pressures materially challenge our asset allocation philosophy, especially the investment rationale for government bond allocations? And should this then entail a different approach to portfolio resilience?

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Portfolio resilience requires an approach that takes into account uncertainty and brings transparency to the drivers of portfolio construction.

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How to build portfolio resilience: The BlackRock approach

While the central bank policy reset is supportive of risk assets in the near term, it has not removed the significant geopolitical and macro uncertainty that is driving the acute need for portfolio resilience. Focusing on simple median return estimates can lead investors astray: It is akin to having one foot in freezing water, one foot in boiling water – and on average feeling fine. Recessions are binary, not average outcomes. Traditional portfolio optimization techniques, because of their sensitivity to small changes in the assumed inputs, often force investors to place significant, subjective constraints around the optimization process. That tries to fix the symptoms rather than the root problem, in our view. Our new capital market assumptions (CMAs) and portfolio construction toolkit seek to tackle these shortfalls head on by offering:

  • An entire range of potential return paths across asset classes and factors, allowing for a fuller picture of the uncertainty inherent within those expectations.
  • A term structure of returns from five years to a long-term equilibrium, making it possible to map potential outcomes over any time horizon.
  • A framework that incorporates explicit connections between asset price behavior through our new models. A change in the macroeconomic environment, such as a structural decline in real (inflation-adjusted) interest rates, should affect the expected returns of all assets.

These linkages, combined with our varied return pathways, allow us to design portfolios that take into account downside risks and bring transparency to the drivers of portfolio construction. We believe that the incorporation of uncertainty in return estimates, the interconnection of estimates and return term structures, and robust optimization are all essential components of truly resilient portfolios.

Does the dovish turn by central banks change the message?

Our multi-asset strategic asset allocation (SAA) preferences reflect:

  • A lower-for-longer environment – our capital market assumptions reflect our base case of modest long-run growth, a continued demand for safe assets, and inflation remaining well anchored.
  • Heightened geopolitical risks – our allocation views are designed to provide resilience to fundamental return uncertainty stemming from geopolitical risks and the late-cycle environment in the US. They do this by considering an SAA that is resilient in a range of downside scenarios, rather than one that simply works best in a central case.

Our SAA preferences show our portfolio resilience approach in action. Despite our central case of low return forecasts and an expected rise in yields, we advocated a broadly diversified portfolio with a material overweight to government bonds for unconstrained multi-asset investors in the US and Europe. This is part of a barbell strategy that upped both equity and government bond exposures at the expense of credit. Such an allocation proved to be well-suited to the sizeable market moves in summer 2019. The appropriateness of this approach for insurers will very much depend on the specific insurance portfolio. Where there is scope, however, insurers need to weigh the greater resilience potential of such a shift against the structural benefits of maintaining large exposures to credit. Sizeable allocations to private markets also remain valuable sources of portfolio returns with low correlation to public markets.

What impact did the recent dovish turn by central banks have on our portfolio recommendations – and why? At a broad asset class level, the effect was limited, albeit with greater change within asset classes. From a return perspective, we had already anticipated low (real) asset returns relative to previous cycles. We now expect them to be lower still. However, what matters most from an asset allocation perspective is the impact on the correlation between key assets such as government bonds and equities because this is the driver of resilient portfolios. The diversification benefits of government bonds could be undermined in two important scenarios:

  1. If market participants thought bond yields had reached an effective lower bound (ELB) in negative territory, falling equity values would no longer coincide with a drop-in yields. That would suggest that correlations drift towards zero, thus curtailing diversification.
  2. Unwinding global supply chains and broader de-globalization could result in lower growth and higher inflation. In such a scenario, interest-rate duration risk could become positively correlated with equity, making shorter duration (or floating-rate) securities preferable to longer-duration assets – both from an anticipated returns and a risk diversification perspective. Inflation-linked bonds would become an additional, substitute diversifier.

Insurers should consider the following when building portfolios today

Government bonds are core
Government bonds are core
Despite historically low yields, government bonds’ role as ballast in portfolios is still meaningful.
A greater role for inflation-protected securities
A greater role for inflation-protected securities
A blend of nominal and inflation-linked bonds in strategic portfolios can create resilience to a variety of adverse conditions.
Diversifying into US Treasuries
Diversifying into US Treasuries
Eurozone investors – including those with liabilities – should increasingly look to US Treasuries as portfolio ballast if rates fall further.
Jean Boivin
Global Head of Research for the BlackRock Investment Institute
Jean Boivin, PhD, Managing Director, is Global Head of Research for the Blackrock Investment Institute and is a member of the EMEA Executive Committee.
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Global Insurance Report 2019:
Re-engineering portfolio resilience
BlackRock’s eighth annual global insurance survey provides perspectives on markets and portfolio construction from 360 senior insurance executives, plus client interviews and insights from BlackRock’s experts.
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Global Insurance Report 2019