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Investors rewarded for risk-taking in 2016 despite volatile first half

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A volatile first half that began with the worst start for the Standard & Poor’s 500 since 1928 and concluded with the UK’s Brexit referendum favoured portfolio diversification during that period, but US investors who owned more higher-risk assets ultimately outperformed their peers during 2016, according to the Natixis Portfolio Clarity US Trends Report.

The year-end review of financial advisers’ moderate-risk model portfolios by Natixis Global Asset Management showed that markets rewarded a completely different set of asset allocations in the last six months of 2016 than in the first six months.
 
The average portfolio in the analysis gained 4.32 per cent in the first half of the year, when the best-performing portfolios were diversified with holdings such as precious metals, international government bonds, emerging market debt and commodities which helped offset equity market volatility.
 
The opposite was true in the second half, when the average portfolio rose 3.77 per cent and the best performers had larger allocations to US high-yield debt and equities – especially small-caps – and less exposure to interest rate-sensitive bonds.
 
The second half also featured a wider variation in performance between portfolios than the first half, with the top-performing quartile outperforming the bottom quartile by 4.13 per cent.
 
“The dichotomy we saw in the markets in 2016 illustrates why durable portfolios are so important,” says David Giunta, CEO for the US and Canada at Natixis Global Asset Management. “Investors should build portfolios geared toward their long-term goals and risk tolerance so they are prepared when volatility strikes.”
 
Investors steadily increased their fixed income allocations in 2016 to 31 per cent at year-end, up 2.7 per cent compared to the prior year and the highest level since the second quarter of 2013. The increase was driven by investment in categories less sensitive to interest rates – primarily multi-sector bonds, high yield debt and bank loans – as investors positioned their holdings in anticipation of rising interest rates.
 
The shift to a rising-rate environment early in the second half favoured active managers in the intermediate-term bond fund category, with more than 90 per cent of actively managed funds in the category outperforming comparable index funds by an average of 1.15 per cent since mid-year. That followed a three-year period where index funds in the category outperformed active strategies by a total of 0.14 per cent, on average, and received 130 per cent of net fund inflows.
 
While fixed income allocations increased in 2016, all other asset classes declined or were relatively flat compared to a year ago: equities were52 per cent, down from 52.9 per cent at year-end 2015; asset allocation funds: 7.2 per cent, down from 7.6 per cent; alternative assets were 5.5 per cent, down from 6.9 per cent; real estate & commodities were 2.1 per cent, up slightly from 1.8 per cent; while cash was 2.2 per cent, down slightly from 2.5 per cent.
 
While allocations to alternative funds were down compared to the prior year, they rebounded 0.5 per cent from the end of the third quarter and illustrated two continued trends – using alternatives to reduce risk; and the use of option-writing funds as a substitute for binds.
 
Allocations within the alternatives category continue to shift from return generation to risk reduction. At the end of December, 70 per cent of alternative allocations in the moderate model portfolios were in risk-mitigating strategies (managed futures, market neutral, option writing and long‐short credit), compared to 30 per cent four years ago.
 
Income-generating option-writing funds were the fastest-growing alternative category, accounting for 31 per cent of alternative allocations, as advisors look for bond alternatives.
 
“Investors concerned about potential volatility brought on by rising rates, valuations, central banks and geopolitical risk would do well to remember the lessons of a year ago,” says Marina Gross, executive vice president of Natixis’ portfolio research and consulting group. “Though a rising tide lifted many investors in the second half of 2016, the heightened volatility of the first half is much more typical and favours broad diversification.”

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