Probability-based investment modelling for professional and institutional investors
Realised volatility continues to march higher every week and we have now got to the danger zone, where this creates the conditions for more volatility – especially if the FOMC is committed to much tighter monetary policy. In these circumstances, traditional valuation metrics lose a lot of their power and investors should assume that markets in one or more major asset classes will become disorderly. We think this has already begun in Nasdaq, Italian government bonds and the Chinese yuan. Other assets, which may follow in due course, include US High Yield, credit ETF’s and US housing.
There is lots of client interest in alternative asset classes, mainly because bonds no longer provide enough income and because they are structurally vulnerable to inflation. This week, we demonstrate this it is possible to generate superior long-term returns by adding REITs to an actively managed portfolio of equities and bonds. The key messages are (1) that the combined portfolio needs to be actively and systematically traded and (2) that exposure to REITs must be properly constrained in order to avoid the savage drawdowns that are characteristic of this asset class. We also note that US REITs have performed very strongly this year, so now may not be the time to start this strategy.
Over the last 25 years, US REITs have provided successful risk-adjusted diversification opportunities when compared with a 50/50 equity bond portfolio. Comparing them with just an equity or fixed income benchmark understates how well they do when compared with a joint benchmark. They perform far better than the other alternatives we look at – hedge funds, commodities and gold. We think the investors underuse the tactical asset allocation opportunity provided by REITs, as opposed to real estate in physical form.
Our global volatility index has just hit a two-year low, but US equities are no longer leading this and are now in a counter-trend, whose strength is disguised by a breakdown in sector correlations. The period of ultra-low volatility is not over yet, but it may not last much longer.