PERSPECTIVES F O R P R O F E S S I O N A L I N V E S T O R S O N L Y. Survival of the fittest: adapting to complex markets March 2018

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1 PERSPECTIVES F O R P R O F E S S I O N A L I N V E S T O R S O N L Y Survival of the fittest: adapting to complex markets March 2018 It would be easy to forecast a completely different story for 2018 compared to 2017, given the current prices of certain assets, such as equities, bonds and commodities. Market growth has been going on for so long and in light of last month s sharp rise in volatility, investors have a crucial choice to make: stay invested or take profits. From a macroeconomic standpoint, there has not been such strong and synchronised growth momentum since before the global financial crisis and we believe this framework will continue to be highly profitable for risky assets. However, market stress events, such as the one we faced in early February, are likely to become more prevalent this year, as inflation risks rise and central banks worldwide unwind their accommodative monetary policies. As a result, we expect the next investment cycle to present more challenges. Investors will have to adapt their portfolios to these more complex financial markets. In our view, simplicity will not work and there is the need for more sophisticated solutions. As Charles Darwin said, It is not the strongest of the species that survive, nor the most intelligent, but the ones most responsive to change. FOCUS ON REAL INVESTMENT RISK A true understanding of risk will be more essential than ever as we move into the next phase of the market cycle. Quantitative Easing (QE) has significantly modified the risk profile of the main traditional asset classes. A reversal of QE is therefore likely to cause another shift in risk/return expectations across these asset classes. However, many investors continue to take a simplistic view of risk. Volatility is a poor proxy for risk The most common measures of risk, historical volatility and VIX, are ineffective as proxies for real investment risk. Volatility is an academic way of defining risk, which makes it an easy measure to use in financial models due to its quantifiable nature. Nevertheless, it is backward-looking and doesn t reveal anything about a future risk of losing money. Meanwhile, the VIX popularly known as Wall Street s fear index is forward-looking, but again it doesn t give any indication of the risk of permanent loss. It is by construction a short-term measure of volatility, which is very reactive to market behavioural sentiment. Despite the well-known limitations of volatility-based risk analysis, volatility is often used as shorthand for riskiness in some popular risk management models. With equity and bond valuations looking stretched, many investors have turned to financial engineering to feed their hunger for yield. There are hundreds of billions of dollars worth of money in various systematic, computer-driven strategies that scale their positions up and down in accordance with how volatility behaves. These models, as we saw in February, will be a source of risk in periods of market stress, amplifying corrections linked to monetary policy normalisation and interest rate reversal. When constructing portfolios, we strongly believe that using volatility measures alone to set asset allocation can lead to a misrepresentation of risk. We recommend using an expected shortfall model, which we feel is a more appropriate measure of risk for two reasons: firstly, it relates to potential losses on capital, which is the true risk investors face; and secondly, it allows us to incorporate additional risk dimensions, including liquidity, skewness and tail risk. Fiona Frick CEO Fiona Frick is Unigestion s Chief Executive Officer. She is a regular speaker at conferences such as the Milken conference, the CFA Institute, Fund Forum, 100 Women in Alternative, and the Robin Hood Investors conference, and serves on the Board of Sustainable Finance Geneva. Fiona was named in 2007, 2010, 2011, 2015, 2016 and 2017 by Financial News as one of the 100 most influential women in the European financial services industry. Read more of our latest investment thinking online: Unigestion SA I 1/8

2 SURVIVAL OF THE FITTEST: ADAPTING TO COMPLEX MARKETS Market stress set to rise Low and predictable interest rates, broad global economic growth, healthy corporate earnings and the growth of passive ETFs all conspired to keep market volatility at bay in In our view, 2018 will prove different. We are likely to face several episodes of market stress, driven by inflation striking back and the return of tighter monetary policy. To help anticipate when such episodes may occur, it is important to consider a broad range of risk measures. In that context, we use a proprietary market stress Nowcaster model, which is a contraction of now and forecasting, to estimate current market stress conditions. This model, which incorporates liquidity, implied volatility and credit spreads, has shown an increase in market stress risk since the summer of 2017 (as shown in Figure 1). The rise has been driven by scarcer liquidity, a trend which is likely to continue as QE is reversed. The liquidity component of our model has been a leading indicator of market stress periods in the past, notably in 2014, when again liquidity tightened ahead of the rise in volatility. Figure 1: Unigestion market stress Nowcaster 90% 80% 70% 60% 50% 40% 30% 20% 10% 0% Source: Bloomberg, Unigestion s calculations, as at 28 February In our view, 2018 will prove different to We are likely to face several episodes of market stress, driven by inflation striking back and the return of tighter monetary policy. Risk of correlation shocks Periods of tighter liquidity imply an increased correlation between equity and bond markets. Therefore, correlation shocks are expected to occur more often at this period of the cycle. This is illustrated by Figure 2, which shows the correlation between US bonds and US equities during previous rate hiking cycles by the Fed. We are currently going through a period of monetary normalisation where the Fed is adjusting its rate, while the European Central Bank has reduced its monthly assetpurchase target. Yields on bonds don t move in lockstep with Fed policy, but they tend to go up when anxiety about monetary policy is on the rise. Furthermore, a major attraction of equities since the financial crisis has been the higher yield of equities versus fixed income, with earnings considered to be the yield of a stock. This will reverse as bond yields rise, making them more attractive relative to equities. Read more of our latest investment thinking online: Unigestion SA I 2/8

3 Figure 2: The correlation between US equities and bonds during Fed rate hiking cycles 1 Fed hikes cycle (Rhs) US Equity / US Bonds correlation Source: Unigestion, Bloomberg. Data from 31/12/1990 to 01/12/ IMPLEMENT A DYNAMIC ASSET ALLOCATION THAT INTEGRATES INTELLIGENT DIVERSIFICATION Given the likely challenges ahead, we believe an active approach to asset allocation will be more important than ever. In our view, the recent market turmoil highlights the need to be both diversified and dynamic when allocating capital. Diversification into alternative risk premia Intelligent diversification means not just investing in a lot of different assets, but in assets that respond differently to common factors. Diversification by risk factor is more robust than diversification per asset class. In that context, diversification into alternative risk premia (ARP), such as carry, equity long/short factors or trend-following strategies, makes perfect sense at this time of the cycle. In a period where traditional assets look expensive, adding ARP with a low correlation to traditional assets can improve the overall risk-return profile of a portfolio, especially in a low yield environment. Here again, the right risk measure should be used when deciding how to allocate to these alternative risk premia. For example, we compared three types of ARP: cross-asset trend following, credit carry and emerging market FX carry. As shown in Figure 3, the historical volatility of these ARP is fairly similar, therefore the simple approach would be to allocate the same proportion of risk for each within a portfolio. However, we have observed that when historical maximum drawdowns are considered, a very different risk picture emerges, which is also illustrated in Figure 3. Ignoring this dimension of risk can lead to the potential risk of loss being underestimated. Figure 3: Volatility versus maximum drawdown for three types of risk premia In a period where traditional asset classes look expensive, adding alternative risk premia with a low correlation to traditional assets can improve the overall risk-return profile of an asset portfolio, especially in a low yield environment. 15% 10% 5% 0% -5% -10% -15% -20% -25% -30% -35% Volatility imum drawdown Cross-Asset Trend Following Credit Carry EM FX Carry Source: Unigestion, Bloomberg. Statistics based on back-tested series using data from October 2005 to December Read more of our latest investment thinking online: Unigestion SA I 3/8

4 Dynamic allocation In a period where market stress events are likely to occur more often, we believe adding a dynamic element to asset allocation models will be essential. A dynamic approach allows investors to adapt their portfolios long-term asset allocation to the prevailing environment. Investors should consider where we are in the macroeconomic cycle in relation to financial market valuations and adjust the allocation strategy as frequently as necessary. At present, we believe investors portfolios should be tilted towards assets that would profit from a growth environment while taking into account that inflation risk is rising. However, it will be important to have the flexibility to lower the portfolio beta through opportunistic hedging in both the currency and options markets. Investors should constantly monitor hedging in areas where the cost of protection seems cheap relative to the reward, should the associated negative event arise. It may also be beneficial to lower a portfolio s beta exposure by implementing relative value trades, i.e. moving from a beta style to one more focused on alpha generation. STAY INVESTED IN EQUITIES BUT ACTIVELY MANAGE YOUR RISK EXPOSURE So how should equities perform in an environment of higher inflation and rising interest rates? Historically, this kind of environment has been positive for equity performance. Figure 4 highlights that equities post higher returns when monetary policy tightens. This comes from the fact that central banks hike rates during good times, when the macroeconomic backdrop is favourable, to avoid overheating. Figure 4: Equity market performance in tightening periods vs. trend average returns 1.80% 1.60% 1.40% 1.20% 1.00% 0.80% 0.60% 0.40% 0.20% 0.00% 0.74% 0.52% 1.10% 0.49% 0.57% 0.29% 0.31% 0.25% 1.02% 0.44% 1.68% S&P 500 EuroStoxx 50 Japan Topix UK FTSE 100 MSCI World MSCI EM 0.66% Although monetary policy is likely to be less and less accommodative in 2018, we still expect most equity indices to continue to perform positively. However, following such strong past performance from equity markets, valuations in some areas are high. Monthly Return - Hikes Monthly Return Past performance is no guide to the future. Source: Bloomberg, Unigestion calculations, as at 31 December Although monetary policy is likely to be less and less accommodative in 2018, we still expect most equity indices to continue to perform positively. However, following such strong past performance from equity markets, valuations in some areas are high, as shown below in Figure 5. The S&P 500 index posted a positive total return for the ninth consecutive year in 2017, marking a record winning streak that was last seen in the 1990s. Investors should therefore be increasingly selective about the equity risk they want to take. Read more of our latest investment thinking online: Unigestion SA I 4/8

5 Figure 5: Elevated valuations across regions 25 Forward Price/Earnings Ratio as of World AC World Developed US Europe Emerging Markets Source is MSCI, Bloomberg BEST, Unigestion, analysis period Actively targeting equity risk With some parts of the market looking overvalued, we believe that a passive approach to equity allocation is a risky proposition. Passive strategies based on market cap-weighted indices are too simplistic in the way they construct their exposure for the kind of equity market we expect going forward. As Einstein said, Everything Should Be Made as Simple as Possible, But Not Simpler. This type of strategy makes no provision for risk allocation: all the risks, good and bad, inherent in the market are present in a benchmark. Furthermore, based on the way they are constructed, market cap-weighted indices will maximise exposure to stocks that have been successful in the past, effectively further rewarding the winners. Their allocation methodology, similar to momentum strategies, can lead to investing in overvalued and overcrowded positions. As a consequence, indices are prone to suffer from sharp corrections when investors start to exit these stocks. In contrast, an active equity strategy allows investors to potentially avoid such unrewarded risks and target intended, remunerated risk more precisely. Positioning for monetary tightening In a period of central bank tightening, investors should consider the sensitivity of their equity portfolio to sovereign bonds. They should protect it as far as possible against interest rate moves through active stock selection and sector allocation. In an environment of rising rates, reflationary and capital-intensive sectors are more likely to benefit. In contrast, highly leveraged sectors such as utilities or real estate are among the most exposed to bond yields. With some parts of the market looking overvalued, we believe that a passive approach to equity allocation is a risky proposition. CONTINUE TO ALLOCATE TO PRIVATE EQUITY BUT BE SELECTIVE Private equity valuations have nearly reached the highs seen before the financial crisis and, due to slowing investment activity, seem to have peaked and stabilised during the second half of 2017, at least in North America and the Asia Pacific region. Read more of our latest investment thinking online: Unigestion SA I 5/8

6 Investor appetite for the asset class nonetheless remains strong. Competition at auction is fierce as private equity sponsors seek to redeploy record levels of committed capital. Given the need to compete on price, sponsors have been willing to put more leverage on their deals and we have seen a spike in average leverage levels in recent months, particularly at the large end of the market. However, leverage is apparently being used more responsibly than before as sponsors are structuring the debt to better reflect the nature of the business. A positive outlook for private equity overall Figure 6: Private equity market cycle Source: Unigestion, as at January 2018 We expect returns from private equity to remain attractive in the years to come, both in absolute and relative terms. The economic background remains supportive overall, with continued growth likely to be positive for top-line company revenues. Private equity tends to perform well when the economy is growing and underperform during recessions, as shown in Figure 7. Figure 7: Performance of private equity across macro risk levels We expect returns from private equity to remain attractive in the years to come, both in absolute and relative terms. The economic background remains supportive overall, with continued growth likely to be positive for top-line company revenues. Note: quarterly returns of US buyout funds based on data from Q to Q Quarterly returns of funds within Pevara are calculated using the Modified Dietz Method. Source Unigestion, Bloomberg & Pevara Furthermore, as it becomes more difficult to make money in traditional markets such as equities and bonds, the illiquidity premium of private equity makes sense in an overall portfolio as a performance booster. Finally, as more and more companies are choosing not to list publicly, the private sector offers a set of interesting investment opportunities not available in the public market. Read more of our latest investment thinking online: Unigestion SA I 6/8

7 Be aware of correlation to equity and credit markets That said, some caution is needed. High valuations in public equity markets could weigh on private equity. Correlation analysis shows that private equity does tend to move somewhat in line with public equity, albeit not in perfect synchronicity as it is less subject to market sentiment. It is interesting to note that buyouts tend to follow the S&P 500 and the MSCI World indices, while venture capital is more related to the NASDAQ. Private equity, especially buyouts, also seem to move somewhat in sync with the high yield market, although with no correlation to the investment grade credit segment. This is because private equity needs leverage and capital-efficient structures to be able to generate the required return. In this current environment, where high yield is expensive and we are entering a quantitative tempering phase, it will be important to avoid excessive leverage. Focus on price discipline and be cautious on leverage Private equity fundraising hit a new record in 2017, with some USD 453 billion raised over the year. As a consequence, finding good investment opportunities and maintaining price discipline in a competitive environment will be the biggest challenges for private equity investors in It will be important to invest in companies that can deliver the required base case return without relying solely on leverage and multiple arbitrage i.e. sector consolidation with synergies, powerful long-term trends and/or opportunistic market dislocations. While we do not think that increasing debt levels should yet be a cause for concern, we continue to back private equity managers whose returns are driven by revenue growth and operational improvements rather than leverage. The average company debt multiples in our portfolios remain below 3x EBITDA. Cheap debt is a great way to optimise returns for investors, as long as it is used responsibly. Given the level of competition, we prefer strategies that allow sourcing deals outside of large auctions. We therefore focus on small and mid-market buyouts or on sector-focused strategies. Smaller deals require deep local knowledge and strong operational capabilities. They are by nature less competitive than larger deals. In secondaries, the plain vanilla acquisitions of stakes in broadly known funds are mostly intermediated and too expensive. Thus, we favour secondary direct transactions, fund restructurings, as well as the acquisition of stakes in quality but smaller and less known funds. If managed correctly, private equity can be a relatively defensive asset class. Investors can target sectors, especially in the small and mid-market, which are less correlated to GDP growth, such as education, healthcare, software or renewable energy. Furthermore, while private company valuations may fall during a slowdown, the declines are usually not as dramatic as in the public markets. Private equity managers have the luxury of time: they do not need to sell in adverse markets but can hold on to their portfolio companies until conditions improve. As it becomes more difficult to make money in traditional markets such as equities and bonds, investors are seeking alternative sources of returns and the illiquidity premium of private equity makes sense in an overall portfolio context, as a performance booster. THE WAY FORWARD As we move further into 2018, our positioning still favours growth assets in order to benefit from synchronised macroeconomic growth. However, investors need to prepare their portfolios for higher inflation, the normalisation of monetary policy and stretched valuations in most traditional assets. While our economic and investment outlook is broadly positive for this year, market conditions are undoubtedly becoming more challenging. Market stress events are likely to become more prevalent, as inflation risks push central banks into tightening mode. In our view, a simple investment approach, which has proved very successful in recent years, will no longer work and more sophisticated solutions will be needed. Read more of our latest investment thinking online: Unigestion SA I 7/8

8 Investing is both a science and an art. The science of investing consists of making decisions based on research and history, while the art demands an understanding of human behaviour and the inefficiencies it can create. Investing requires then having the humility to realise that some aspects are hard to predict and that it is important to be nimble and adapt to change. As Aldous Huxley said, The charm of history and its enigmatic lesson consist in the fact that, from age to age, nothing changes and yet everything is completely different will offer the perfect scenario to judge how well asset managers can adapt their approach to the changing environment and how successfully they can apply both their science and art in navigating these more complex markets. Important Information Past and simulated performance is no guide to the future, the value of investments can fall as well as rise, there is no guarantee that your initial investment will be returned. This document has been prepared for your information only and must not be distributed, published, reproduced or disclosed by recipients to any other person. This is a promotional statement of our investment philosophy and services only in relation to the subject matter of this presentation. It constitutes neither investment advice nor recommendation. This document represents no offer, solicitation or suggestion of suitability to subscribe in the investment vehicles it refers to. Please contact you professional adviser/consultant before making an investment decision. Where possible we aim to disclose the material risks pertinent to this document, and as such these should be noted on the individual document pages. Some of the investment strategies described or alluded to herein may be construed as high risk and not readily realisable investments, which may experience substantial and sudden losses including total loss of investment. These are not suitable for all types of investors.. To the extent that this report contains statements about the future, such statements are forward-looking and subject to a number of risks and uncertainties, including, but not limited to, the impact of competitive products, market acceptance risks and other risks. As such, forward looking statements should not be relied upon for future returns. Data and graphical information herein are for information only and may have been derived from third party sources. Unigestion takes reasonable steps to verify, but does not guarantee, the accuracy and completeness of this information. As a result, no representation or warranty, expressed or implied, is or will be made by Unigestion in this respect and no responsibility or liability is or will be accepted. All information provided here is subject to change without notice. It should only be considered current as of the date of publication without regard to the date on which you may access the information. Rates of exchange may cause the value of investments to go up or down. An investment with Unigestion, like all investments, contains risks, including total loss for the investor. Document issued on: Ref: Read more of our latest investment thinking online: Unigestion SA I 8/8