Gareth Abley (left), Colin Tate, Ross Etherington and Aron Pataki

Fund managers need to construct robust multi-asset portfolios with both defensive hedges and alpha generating assets as well as stabilising investments that can produce non-correlated returns in the current inflationary environment.

“In the current inflationary environment, you certainly want to have inflation hedges in your portfolio, have exposure to companies with strong pricing power and to companies that can generate cash flows independently from the business cycle and these tend to be in defensive sectors,” said Aron Pataki, portfolio manager, Newton Investment Management, speaking at Investment Magazine’s Absolute Returns Conference in Sydney this month.

“There are opportunities in some structural growth areas like renewable energy, defence and healthcare. On the other side, you need to have stabilising assets, hedging positions that can produce non-correlated returns with the core of a portfolio.” Newton currently uses the US dollar as part of the firm’s risk management and volatility policy.

More risk

After a long period of low inflation and relative benign markets, Pataki said investors can expect more volatility, potentially lower expected market returns and shorter boom bust cycles as inflation rises. The move by central banks globally to raise interest rates to control inflation has also introduced more risk into financial markets, given the high gearing levels of many companies and households when interest rates were at an all-time low.

“This tightening cycle carries a lot more risk because governments are leveraged, the trading public is much more leveraged, household exposure to equities is much higher than before,” he said.

Investors and fund managers need new risk-management policies to navigate current market conditions as the inverse relationship between equities and bond markets – a key feature of the low and stable inflation regime in the last 20 years – has broken down. “This year has been a tough year for both core assets of a traditional portfolio,” said Pataki. “What is even more surprising than the negative performance of these two asset classes is the breakdown of correlation between the two that persisted for two decades.”

Finding alpha is key in the current market said Ross Etherington, chief investment officer of EISS Super, the $6 billion super fund in the midst of a merger with Cbus. “In terms of whether it’s equities or bonds, the alpha that you can get from your equity portfolio in particular, is going to be more important going forward,”

Higher inflation to stay

Pataki is of the view higher inflation is unlikely to abate in the short to medium-term given the move from globalisation to localisation. Countries rushed to build national stockpiles, supply chains and manufacturing capabilities to avoid being dependent on international trade that was severely disrupted in the pandemic. “The biggest shift is moving away from globalisation to localisation and that is very inflationary in nature,” he said.

Labour shortages with falling participation rates as well as the decarbonisation of global energy systems are also feeding into inflation pressures, according to Pataki. “The other major long-term structural inflationary trend is connected to the green energy transition which will require significant investment from governments. At the same time, we are seeing a reduction in labour force growth.”

Assets in demand

There has been huge demand from investors for real assets that includes private equity, infrastructure and property due to their defensive characteristics, particular in a softening economic cycle.

“Real assets are in high demand at the moment as they are often seen as an inflation hedge providing some downside protection which is arguably just because they’re valued less frequently,” said EISS Super’s Etherington.

However, he warned private equity assets were “very high risk, you’ve got to pick the right businesses to get into and a lot of due diligence is required to get those right businesses.”

MLC has evolved its alternatives strategy to focus in niche areas such as what the firm terms as “esoteric speciality finance” said Gareth Abley, head of the firm’s alternatives strategies. “A lot of conventional private credit is very similar to public credit, in terms of its risk characteristics, and we’re looking for something that’s very different to that given our focus on de-correlation.”

The bucket of assets in this strategy includes legal finance, accounts receivables financing and natural catastrophe reinsurance. “We try to identify assets with key characteristics, uncorrelated returns, and attractive risk adjusted returns in their own right,” he said.


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