With interest rates still so low by historical standards, fixed income is potentially overvalued. In addition, low interest rates for a long period of time have led to stretched valuations in other asset classes such as equity and credit. Benjamin Nastou, CFA, and Natalie Shapiro, Ph.D., Quantitative Portfolio Managers at MFS, published recently an Investment Insight, highlighting that in this circumstances, a balanced portfolio of stocks and bonds can probably be expected to generate lower returns than such a portfolio would have delivered historically.
Therefore alpha — or return over the benchmark — that can be added through active management will probably be more important than it has been historically. For example, an extra 100 basis points of return represents a much higher percentage of expected total return at 4% – 5% than at 8% – 9%.
In this kind of environment, the quantitative portfolio managers at MFS would think about making a few sensible tilts to take advantage of investment opportunities that may help to improve risk-adjusted performance. Note that these suggestions are based largely on the valuation component of their quantitative process highlighting that while valuation works well in the long run, patience may be required over the periods when valuation does not work as an investment signal.
These are their suggestions:
- Exercise caution overall. With the possibility that both stocks and bonds may be overvalued, we would expect to hold a little more cash than usual.
- Avoid taking excessive duration risk. At such low interest rates, bond investors are probably not being compensated for the risk of rising rates.
- Exercise caution with high-yield and high-grade bonds. We may not be seeing asset quality issues, but with discount rates and credit spreads so low, high-yield and high-grade valuations appear stretched. This suggests that bond investors are not being compensated for credit risk.
- Exercise caution with respect to US equities. The United States has enjoyed stronger performance relative to most other markets, leaving US stocks looking expensive by historical standards.
- Avoid emphasizing small-cap over large-cap equities. Within the US equity market, small caps have had the strongest performance and look the most stretched from a valuation perspective. For context, when small caps were more expensive than large caps in the early 1980s, large caps outperformed small caps by 6% annually over the subsequent decade, and the valuation gap between small caps and large caps is even greater now.
- Consider non-US and emerging market equities. This may be challenging given the lingering economic problems in some emerging countries, but from a valuation perspective, we believe stocks in these markets appear priced to deliver returns that are more in line with their historical averages.
Of course, no investment strategy — including asset allocation — can guarantee a profit or protect against a loss. But according to MFS, these steps may help to make the most of a low-return environment. The authors conclude the report saying: “And we always advocate the importance of investing over a longer time horizon, establishing a broadly diversified portfolio and rebalancing regularly as the cornerstone of a disciplined investment process, and working with skilled managers who have demonstrated the ability to add alpha through superior security selection in stock and bond markets”.