How to position portfolios to respond to market-changing megatrends

Bill Schwab, former global head of real estate at the Abu Dhabi Investment Authority, sets out a practical approach for investors

Global real estate trends in 2018 were varied; some positive of value and cashflow increases, others negative. Some were cyclical in nature, driven by economic and financial cycles – think investment demand for development projects leading to increased development volumes and decreasing yields – while others were secular and stand out as portents for the future – trends like the demand for logistics facilities that owners and operators will find increasingly impact on operations and economics regardless of cycles.

To keep on top their potential impact on investments, portfolio managers should address these questions in the months ahead:

Which 2018 trends should we act upon and, critically, how should we act in order to position our portfolios for the future? This is a price insensitive view as it looks to underlying economic trends of demand and supply for goods and services.

What does current and/or expected market pricing tell us about how managers should act? This adds the price perspective to our portfolio management considerations and involves the pricing risk appetite of your organization.

How do we maintain alignment with our views and those of our professional managers – third-party investment managers, property managers and internal teams? This is the execution perspective to our portfolio management decisions.

By formulating responses to these questions, investors can incorporate trend views into their portfolio management. Let us use one of the most important themes from 2018 – the escalating headwinds the world is facing – as a case study. Here are four headwinds in play right now:

Geopolitical uncertainty and leadership volatility – Eurozone stresses including Brexit, trade war tensions, internal political stresses in many major countries, and regional and superpower rivalries – which may contribute to slowing economic growth and downward pricing pressures on investments.

Debt constraints that lead to lower consumption than would otherwise be the case.

Slowing demographics – 80 percent of current world GDP is concentrated in aging countries, and aging impacts savings and spending patterns, and its effects can contribute to a continued low-return environment.

Growing income inequality which can distort  consumption patterns, increase political dysfunction, and change investment functions.

Bill Schwab

And here is a recommended four-step response. First, hedge your investment bets. You can diversify your holdings, curtail exposure to the riskiest markets where that risk exceeds your risk appetite, eliminate or greatly reduce exposure to existential risks – those that could threaten your investment program if they turn against you – and raise or conserve cash to be positioned to take favorably priced risks when they arise. Second, focus on risk pricing. Let pricing drive the management of risk. It is important to understand what is discounted in market prices – that is, the valuation impact of a risk on you if that risk is realized adversely – and consider the impact X probability = [expectation] of the risk.

Where risk is priced to the probable worst-case scenario, consider taking the risk if it is well-priced for you. In other words, invest if the probability of an adverse result is relatively low and the price discount is relatively high – the investment is ‘priced to worst’ or close to it – and the impact of the downside case being realized is acceptable. Many asset repositioning plays and distressed debt opportunities have asymmetrical risk payoffs – more upside than downside as current pricing reflects the downside – and can be attractive investments.

Third, invest with a ‘margin for safety.’ Some investments will offer you a  discount to replacement costs and to long-term pricing which can be attractive if the long-term prospects for the investment justify confidence in it. And, consider investments where the margin for safety is a business process gross margin such as development and renovation (manufacturing margins).

Fourth, consider modifying your compensation and incentive arrangements so that your managers are aligned with you on volatility. Existing arrangements often incentivize external managers to add the highest level of volatility within investment constraints in order to maximize the value of their performance optionality. Internal managers often resist taking appropriate investment risks – the ‘priced to worst’ example above – given the asymmetry of the payoff to them; fired if it goes against you, an incremental one-time bonus uplift if it goes for you. Do not expect your managers to act against their own interests. Design programs to incentivize your managers to ‘do the right thing’ by the portfolio and pay them accordingly.