Multi-Asset Class Investing

Wider opportunity set gives smoother returns

Originally published in the September 2008 issue

Over the long term, investors have received a premium in return for investing their capital in risky assets, whether it is in equities, bonds, property or commodities. Over the past decade, equities have not delivered any capital return to investors and, during the ‘tech wreck’, investors who invested solely in equities lost 40% of their capital. On the other hand, investments in government bonds, property and commodities all delivered very strong returns during the melt-down in equities in the first two years of this decade. This discrepancy underlines the fact that different asset classes deliver varied returns due to the different drivers of their valuation. The fact that they are not completely correlated with each other, in fact these asset classes often have negative correlation with each other, means that the level of risk in a portfolio can be reduced without sacrificing expected return. This is just one of the beauties of a multiple asset portfolio.

Another is that the broad opportunity set of a multiregion multi-asset approach means there will always be opportunities available. Thus, a flexible strategy, which can capture investment opportunities without a specific bias to any particular region or asset class, allows the targeting of consistent absolute returns, regardless of where we are in a market cycle.

Investors who embrace the potential for multi-asset investing give themselves many more opportunities, and also the potential for much smoother returns, than investors who limit themselves to a single region or to a limited number of asset classes. There is nothing magical in this approach.

There is a vast array of compelling opportunities in financial markets at the moment:

Long financial credit

are the Chinese symbols for crisis. The Chinese also use the same symbols for opportunity. We believe this current credit crisis is now presenting incredible investment opportunities, particularly within credit issued by financial institutions. Buying credit from a financial institution during one of the worst credit crunches ever may not sound like a clever idea and we do expect credit markets to remain challenging from a trading perspective for at least the remainder of this year. However, the returns when weighed against the risks are very compelling.

Over the long term, equities have beaten cash by roughly 4% per annum. Subordinated bonds from AA and A rated financial institutions carry a much lower risk than equities, but are offering an equity-like risk premium at the moment. Spreads on subordinated debt moved to LIBOR +5% per annum at the end of the first quarter of 2008, up from less than a 1% spread in the Summer of 2007.

Before a bank defaults on these bonds, it will do a rights issue, cut dividends and equity could fall to zero….and even in that scenario the most likely outcome is a bail out from the relevant central bank. Subordinated debt was paid in full to Northern Rock holders, as with Bear Stearns. Central banks will not allow the financial system to collapse. All these factors make financial bonds a very safe investment, but because of massive deleveraging and very high risk aversion, spreads more than compensate for the small risk one takes.

Long strong financials equities/short weaker regional financials equities

We believe the financial crisis has also provided huge potential for a relative value trade. We expect that strong banks will not benefit from the ongoing credit crunch, but will continue to strengthen vs weaker banks with strained balance sheets. Banks with stronger balance sheets can take advantage of wider margins on new business and grow. Banks with weaker balance sheets must shrink and absorb losses. Banks which are viewed as strong will also gain client attraction, while clients will avoid and continue to move away from weaker banks to further exacerbate the weakness in weaker banks.

Short front month Natural Gas Index/long longer-dated natural gas contracts.

US natural gas prices lagged oil, coal, petrol and European and Asian Natural gas prices in 2007. In the first quarter of 2008, US natural gas spot prices have rallied significantly, but have sold off much more sharply than oil in Q2. Longer-dated contracts remain depressed. This has opened up a great potential investment. 2011 natural gas futures are now cheaper than coal on MMBTU basis. Natural gas produces half the emissions of coal-fired power generation and there will be huge political pressure to move away from coal and to cleaner natural gas because of this. We also expect upward pressure on US natural gas prices as every day it becomes more of a global market. Historically, natural gas could not be transported over the ocean, but with current liquefaction technology, US natural gas is increasingly being shipped as liquid natural gas to Europe and Asia, where prices are much higher. This trend will continue, boosting demand for US natural gas. Finally, oil and gas exploration and production companies are shifting capital expenditure towards oil because of the price spike and this is coming at the expense of natural gas exploration. All of this will translate into strength in longer-dated contracts.

Shorting near-month contracts creates a huge advantage in terms of the roll. Because of the seasonality in natural gas futures market, as the near-month contract expires, you consistently roll to a higher priced future. A short strategy means as you close your near-month position each month you are buying a low priced future and selling a more highlypriced future, resulting in a very consistent carry.


When the baby boomers were born there were a little over 2 billion people on the planet, and by the time the last of them dies off, there will be over 9 billion. This will put tremendous demands on many areas, from commodities and the environment to food, and, perhaps most importantly, water. Water infrastructure has been neglected for decades in many areas and the urbanisation of the world has put more stress on this ageing infrastructure. Investors can’t trade water like other commodities, as it is not priced on a global market and is driven by regional supply and demand factors, since transportation is generally not cost-effective. We believe equities involved in many aspects of the water industry will be well positioned in a slowing economic environment, because there will need to be capital spending on water regardless of the strength of the economy. We expect strong earnings growth potential from equities involved in water treatment, purification, infrastructure and distribution, as well as desalination.

Agricultural Commodities – short the standard index and long longer-dated futures

Today, grains are used for food, feed and fuel. Demand in all these areas is rising, and will continue to rise, significantly. Because of this we remain favourably disposed to agricultural commodities. Despite a very positive scenario for the agricultural complex, the biggest short position in our portfolios for the past year has been to sell the S&P GSCI Agricultural index. The persistent front to second month contango across wheat, corn and soy beans has meant that the standard agricultural indices have significantly lagged spot price movements, while also significantly lagging our longer-dated positions, which we are net long. A structurally flawed index will continue to lag more efficiently placed long positions, and is a great way to combine a source of beta with alpha from the roll arbitrage.

Long Asian currencies vs US$

Huge current account and fiscal surpluses and much higher economic growth will continue to drive strength in Asian currencies vs US$. The fact that as an investor you get paid a positive carry to put this trade on makes it a low risk, steady earner, with the potential for significant returns in the event of a US$ crisis, or a de-pegging of any Asian currency vs the dollar.

Patrick Armstrong is Co-Head, Multi-Asset Group, Insight Investment. Dr Ana Cukic Munro is Director, Portfolio Strategy and Construction, Insight Investment.