Higher risk-reward investment strategy may have more appeal during period of consolidation

The principle of a well-balanced portfolio dictates a prudent mix of asset classes, but it also allows for a proportion of picks towards the higher-risk end of the spectrum. And, with the next six months increasingly seen as a period of likely consolidation in major equity markets, private investors have particular reason to take a fresh look at some of the less obvious options.

“Potential opportunities, which may have higher inherent risk but offer a higher return outlook currently include emerging market equities and bonds,” says Fan Cheuk-wan, head of investment strategy and advisory, Asia, for HSBC Private Banking. “While emphasising that investors should remain prudent and globally diversified, we see ... tailwinds expected to drive Asian emerging market performance, even in currencies, and are slightly overweight towards Latin America.”

A detectable change in global risk appetite supports this prognosis, along with signs of sustained, synchronised economic growth, progress on structural reform and positive high-frequency data. At some point, a weakening US dollar is also expected to act as a favourable driver, with pending US interest rate hikes already fully discounted by the broader market and inflation expectations easing.

“That bodes well for emerging markets and translates into lower funding costs for countries which rely on US dollar debt financing,” Fan says. “In Mexico, especially, we see upside potential and believe the trade protectionism risk may offer a play. It has been over factored in by the market, but the underlying fundamentals remain resilient, and Mexico should benefit from the cyclical global economic recovery.”

In Asia, Fan has a preference for China and India, where the risk-reward profile “looks compelling” and where policy support, stronger corporate earnings and inflows of liquidity point to escalating returns.

Regarding other themes, she has a marked liking for health care, renewable energy, consumer discretionary and internet-related stocks. “China’s new economy sector is expected to deliver attractive investment opportunities in the next six months. Although valuations are fairly high, much stronger than average earnings growth continues to support valuation and reinforces our conviction. And, as the ‘next big thing’, I think investors should focus on the upcoming opening of China’s capital markets, which will have an impact on global asset allocation in the longer run.”

According to James Cheo, Bank of Singapore investment strategist, one option in a world where growth remains healthy, but risk assets are fully valued, is to look for returns through carry and rotation.

“At the same time, though, it makes sense to manage risk by lowering bond duration, buying hedges, and diversifying the use of hedge funds.”

He notes that carry strategies tend to perform well in a sideways market or one entering a phase of consolidation. They are designed to pay income in the form of a coupon or dividend and, as such, are less exposed to outright equity market risk.

A more defensive dividend idea is to rotate out of outperforming stocks into laggards. It is always worth considering simple fixed-income strategies around high-yield and emerging market bonds. “While most markets look fully valued now, volatility is one of the few asset classes currently at an all-time low,” Cheo says. “This offers the opportunity to hedge against tail risk or to take a directional bullish view on volatility.”

He also points out that, in the search for higher returns, investors have shown increasing interest in deploying “patient capital” into less liquid or private market alternative investment such as private equity. This often imposes restrictions on withdrawals for seven to 10 years before fully returning capital and profits to investors.

However, as Cheo explains, inefficiencies common to such illiquid investments can enable a higher return premium because private equity investment entails an element of asymmetric information, where some managers have better knowledge and a more active role, unlike passive investors in a marketable security.

“These advantages often allow private equity investors to achieve returns that may differ substantially from public market indices,” Cheo says.

He adds that the rally in “risky” assets since the end of last year was largely due to the improvement in the economic cycle. However, with growth moderating, it is difficult to justify much upside.

“Equity valuations are challenging in many markets,” Cheo says. “We believe market consolidation will persist. The current pace of earnings will be hard to sustain, given our view that the macroeconomic backdrop is as good as it gets.”

That said, he suggests that investors with an eye to specific themes and newer plays should be thinking about the health care sector and companies behind innovative cancer treatments.

“The structural factors of an ageing population and rising affluence make the health care sector a solid long-term investment,” Cheo says. “In contrast, we caution investors against being too overweight in long-dated and low-yielding developed market government bonds. The bond rally has depressed them to a level that makes them highly vulnerable to a market reversal.”