By Stuart Katz, Chief Investment Officer
June 24, 2021 – Despite rapid and unpredictable change in the world, many investors have remained steadfastly focused on near- and medium-term performance, settling into a comfort zone of smooth market assumptions. This sense of complacency is especially concerning with current lofty valuations providing a limited margin for safety across asset classes.
But the pandemic and other transformative events of last year have been a wake-up call for those investors that portfolios on their own are no match for severe threat or extraordinary change. To survive disruption and thrive in the long-term, we believe that portfolios need to look beyond short-term performance and basic asset allocation. In short, portfolios need to “construct resilience.”
COVID-19 has redefined our understanding of black swan impact. But it is part of a succession of major transformations that have challenged traditional approaches to portfolio construction. The digital and technology revolution, climate change, government policies and geopolitical uncertainty have significantly impacted performance, and will continue to do so. Severe risk events will become more frequent but less predictable, unfolding faster and in more varied ways.
The digital revolution has increased the availability of data, the degree of connectivity, and the speed at which decisions are made. This offers transformational opportunities but also comes with potential for large-scale dispersion between industry winners and losers. The changing climate presents structural shifts to companies’ risk-return profiles, which will accelerate nonlinearly.
Companies need to balance concerns for their immediate bottom line with pressures from governments, investors and society at large, all while preparing for the possibility of intensifying health crises, industry disruptions, geopolitical conflict, social upheaval, and natural and technological disasters.
Capital Preservation and Long-Term Growth
To achieve true resilience, we believe we must focus on three dimensions, the first of which is capital preservation and long-term growth. In our view, portfolios should intentionally allocate to certain asset classes which balance short- and longer-term goals based on a financial plan. With a solid capital position and sufficient liquidity in the face of potential liabilities, investors can better weather rapid declines in market conditions and counter detrimental behavioral tendencies such as recency bias. As technology becomes a larger component of all industries, the line between growth and value will likely blur and make way for increased attention on bottom-up geographical, sector and company diversification decisions.
Thematic Returns
Next on the list is thematic returns. We think resilient portfolios should maintain robust exposures to durable trends that can both flex to meet disruption in public market performance as well as remain stable in the face of macroeconomic cycles, all without sacrificing quality. These investment portfolios should strive to integrate emerging market consumer, healthcare innovation, digital infrastructure and environmental, social, and governance-related (ESG) trends, among others.
Combining traditional investing methodologies with ESG-related insights, for example, can help improve long-term outcomes for investors, as companies with strong practices regarding material ESG issues have potential to outperform those with poor characteristics. In particular, we believe companies managed with a focus on sustainability are better positioned to weather market storms than their less sustainable peers. We believe these thematic decisions will help make the portfolios perform better in normal times, not just in the face of unpredictable threat or change.
Alternative Strategies
Lastly, we look for opportunities to supplement current traditional core public holdings with alternative strategies. In our opinion, ongoing resilience requires embedding certain active managers who invest with an ability to structurally control and influence company outcomes.
We believe this value creation focused approach builds resilience because selective alternative strategies can incorporate anticipation and response capabilities into their investment processes in times of dislocation.
The goal is to strengthen the portfolio in normal times and increase its ability to withstand and adapt to threats, but also accommodate more subtle investment landscape changes and the risk/reward trade-offs that can help to achieve diversified or enhanced returns and reduced volatility.
The Path Forward Initiative
Conduct portfolio “health check”
We recommend that investors seeking to build resilience take three steps First, conduct a portfolio “health check,” assessing the portfolio’s current level of resilience. Investors can ask: How resilient is the portfolio overall and across each of the three dimensions of resilience? They should also ask whether they have the investment capabilities, tools and judgment to determine if the portfolio can sufficiently anticipate and respond to the next disruption or crisis.
Determine degree and nature of resilience
Secondly, determine the degree and nature of resilience needed for the future. For this step, they should ask: What types of threats or potential change matters most? What gaps exist across each of the resilience dimensions measured over various time periods?
This analysis should consider various stress scenarios, such as the impact of a digital transformation creating industry winners and losers. It should also consider industry and asset class specific dynamics, such as rapidly changing levels of regulatory oversight, and global dynamics, such as climate change, inflation, taxes and geopolitics, that may pose the greatest threat to the portfolio.
Design approach to building and maintaining resilience
Lastly, we turn our focus to designing an approach to building and maintaining the resilience needed based on the financial plan. Here, investors should identify where they most need to shift or supplement current approaches. Maintaining resilience requires a deliberate investment process that dynamically monitors portfolio construction over time.
Investors that understand the resilience they need for the future can thoughtfully implement practical change today. In case of vulnerabilities, this may mean transforming in big or small ways to enhance resilience directly. But, as importantly, investors should look to build resilience into any portfolio as we are certain that no one knows what tomorrow will bring.
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