New ETF strategies add real-assets as a hedge for uncertainty
by Chris HuemmerMr. Huemmer is Senior Investment Strategist at FlexShares ETFs. Visit www.flexshares.com.
If recent market movements have taught us anything, it is to expect the unexpected in the coming months. With inflation and interest rates at levels not seen since the 1980s, and both stocks and bonds being challenged, the future is anything but predictable. While the latest CPI data suggests that inflation may be slowing, advisors and investors are nonetheless left with many questions heading into new year. How quickly will inflation subside? How will the Fed react and what will be the impact? Can we avoid a prolonged recession?
While there remains much we don’t know, there’s one thing that’s practically certain: volatile conditions will continue through year-end and there are more potential headwinds coming to markets over the next few months. Advisors should be prepared to help clients adjust their portfolios accordingly and brace for what likely will be lower returns than historic averages. There are several strategies that advisors can consider to help weather the storm and find new opportunities.
Mitigate Inflation with Real Assets
With inflation likely to remain elevated through next year, advisors can focus conversations on asset classes that have proven additive in inflationary environments. For example, historically, real asset categories – such as natural resources, infrastructure and real estate – have demonstrated strong correlations to inflation over an intermediate to long time horizon. As an added benefit, they’re also proven to enhance portfolio diversification and provide regular cash flows through dividend payments.
A combination of these three asset classes can help hedge against volatility irrespective of where we are in the economic cycle, given they each tend to perform best during different environments. Typically, real estate tends to perform well early in an economic expansion as interest rates are low and the anticipation of growth leads to increased demand in the asset class. Natural resources and commodities tend to do well at the peak of the economic cycle when demand and production output is traditionally at its highest point. Finally, infrastructure tends to do well late in the economic cycle when falling interest rates and high cash flow help defensive businesses benefit from inelastic demand for their services.
Within each of these three asset classes, there are also specific considerations we recommend advisors keep in mind to improve the risk – return profile for their clients. Beyond exposure to a sector alone, advisors should consider other factors like geography, quality controls and supply chain.
When it comes to natural resource equities, we advise focusing on the ‘upstream’ portion of the supply chain on those companies doing the producing and extracting. Upstream companies may benefit from raw material price increases, while downstream companies may be impacted by labor and input costs beyond changes in natural resource pricing.
On the infrastructure side, investors should look beyond traditional projects like roads, bridges, energy assets, and water and waste management for a portfolio that also includes more modern components. Critical infrastructure in today’s world includes access to data through cellular towers and broadband networks as well as “social infrastructure,” such as postal systems and healthcare facilities. These modern components bring additional diversification and potential new revenue streams.
For real estate, one key consideration for advisors is to explore global real estate. As real estate’s appeal continues to grow, we believe that taking full advantage of this sector’s opportunities requires a broader focus than just U.S.-based assets. Our research suggests that a global approach to real estate investing can offer additional diversification opportunities and has historically been less volatile than U.S. real estate securities.
Get Defensive with Low Volatility
One challenge facing advisors today is how to lower risk across the asset allocation when traditional risk controlled assets are delivering negative performance and are increasingly volatile. One alternative to moving out of equities to lower portfolio risk is to maintain equity exposure and shift to a strategy focused on lowering volatility across the equity allocation.
There are a few compelling reasons to use a low volatility approach in today’s macroeconomic environment. Historically, low volatility strategies have performed well during economic slowdowns and contractions. As investors anticipate the potential of a soft or hard landing by central bank monetary policy, these economic outcomes become more likely. Secondly, well-designed low volatile approaches can offer asymmetric returns offering downside protection while still participating in the upside of market recoveries. As equity markets experience more volatility spikes to both the upside and downside, this approach may be compelling to advisors.
Combining low volatility with a focus on quality has historically been beneficial. Research conducted on the Russell 1000 Index’s returns from 1998 to 2016, found that the lowest quality stocks tend to experience higher levels of volatility. As such, a quality combination could further reduce volatility and add incremental returns. A few good indicators of a company’s quality would include robust cash flow, strong profitability and a prudent deployment of capital.
If not designed effectively, traditional low volatility strategies may introduce unintended sector concentration and potentially trade price volatility for interest rate risk, as well as provide less upside capture and less downside protection than investors anticipate. However, with proper diversification controls in place, advisors can minimize this risk while still capturing some of the gains that come during positive markets.
Find Income with Quality Dividends
Dividend income can also act as a stabilizer to equity returns in volatile periods. This may be especially important in today’s equity markets as rising labor and material costs and continued monetary tightening can depress asset values for the next several years. Historical averages have also proven that dividend yield does well during periods of economic contraction.
For the last couple of decades, the balance between the two components of total return – dividend income and capital appreciation – has been thrown off by the outsized returns rising asset prices have delivered to investors. However, one does not have to look too far back to find that this hasn’t always been the case. Following the dot com crisis, the decade ending in 2010 experienced negative price returns, only experiencing positive performance over this “lost decade” through returns from dividend income. This is not an isolated occurrence, as you can find several decades where the majority of total return performance came from dividend yield and not price appreciation. This reliable dividend income is especially important to advisors during periods of higher inflation, as a portion of nominal returns are eroded in real terms by inflationary pressures.
Advisors may want to keep a focus on quality here as well. Too often, the sole focus is on yield without an evaluation of whether that yield is sustainable. By evaluating the financial health of a company through a quality factor, we can gain confidence that the dividend is better covered and the company has the ability to grow its dividend as warranted. We also find this to be a more effective approach than looking at past dividend payments as it has the potential to capture the company’s current environment better than historical payments while also being able to evaluate new dividend payers immediately. Waiting for ten years or more of dividend payments limits the opportunity set that advisors can tap into for yield while also potentially skewing the portfolio away from sectors that have a significant number of new dividend payers.
Focus on Yield with High Yield Bonds
As investors seek alternatives to global equity market risk, advisors may also want to consider looking at high yield bonds, which we consider the least risky risk asset. It’s worth noting the historic benefits of high yield during periods of rising rates. High yield bonds had an average one-year return of 4.3% during the past four Fed rate hiking periods, vs. 2% for investment grade. We believe they remain a strong option for diversification and income generation.
As 2023 commences, the concerns of your clients will continue to focus on how persistent inflation pressures are and how this may effect monetary policy and the global markets. By staying grounded in quality and diversification, you can help investors find returns and opportunity through strategies such as real assets, low volatility, dividends and high yield credit. No one can say with complete certainty where the market goes from here. Whatever the case, the key is to find stability through innovative strategies.