Global Investment – The Ideal Portfolio

By M. Isi Eromosele

In a world of unprecedented uncertainty, it is no longer possible to optimize investment portfolios on an asset class by asset class basis, nor are naïve asset allocation strategies acceptable.

One should never assume that the future will resemble the past, unless there is strong reason to believe so. The experience of the stable 1980s and 1990s has caused many lazy investment habits to get institutionalized as conventional and acceptable practice as market participants are learning to their cost.

More focused investment strategies are required.

All investors should strive for a multi-asset portfolio, designed to deliver profits in as many of the scenarios that can be anticipated over the next year – from outright market

crisis to sustained recovery.

The portfolio should be liquid and, for all intents and purposes, unlevered (with the exception of some relative value positions and some substantial long volatility or option positions).

The portfolio should be divided into five main parts:

Strategic assets

Emerging markets equities and bonds, EMFX overlays, gold and commodities. These are assets considered to have the biggest positively-biased asymmetric pay-off profile, on an option-adjusted valuation basis, across multiple scenarios.

This involves an assessment of the nature and intensity of each scenario against the volatility adjusted valuation of the asset in question.

Defensive assets

These are principally long regulated utility positions in Europe. These are assets that have historically outperformed during periods of high volatility.

Defensive hedges

These include equity variance swaps and a number of short dated currency and rate option positions. These are positions that statistical analysis reveals to perform well in dislocated markets and market crises.

A relative value book

A book in which one of the largest trades is a short position in non-financial European equities versus selling protection on the iTraxx Crossover index.

A currency overlay

This overlay should consist of long emerging market foreign exchange versus EUR

and GBP.

There is currently no excess cash recommended but there are large cash positions available against the face amount of derivative positions.

The rationale behind this mix of asset selections is as follows: There is recognition that the unstable world we live in will not last forever. Indeed, it is expected that by the end of the decade, we will enter a world of lower real growth, of emerging market currency appreciation and of possible higher inflation.

In such a world, owning the longest duration, highest real-yielding assets available is a good strategy. Ideally, these should be denominated in emerging market currencies (e.g. Brazilian inflation-linked bonds); or should be assets capable of being hedged back to emerging market currencies (e.g. Western European regulated utilities); or assets that mirror the behavior of emerging market currencies (e.g. agricultural commodities, gold).

Each of these asset classes should be bought whenever they are attractively priced, using capital accumulated by astutely navigating the current treacherous markets.

We are overweight equities versus rates because our analysis indicates that the equity risk premium for equities is now at unprecedented levels versus rates, even on an option adjusted basis.

In credit, focus on crossover paper because they have cheapened as much as equities (when you compare equity risk premia against volatility adjusted credit spreads).

The rationale behind the defensive hedge selections is as follows: there is recognition that in the short-term, there is a very considerable risk of systemic market failures with about a 40 percent chance of negative shocks ranging from a prolonged bear market in sovereign bonds to a market crisis.

The defensive positions are selected using option-based analytical tools that identify asymmetric pay-offs: trades that should perform well overall in highly volatile markets and also when strategic assets under-perform.

M. Isi Eromosele is the President | Chief Executive Officer | Executive Creative Director of Oseme Group - Oseme Creative | Oseme Consulting | Oseme Finance

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