Building a growth portfolio during times of market volatility requires not only an understanding of the macro landscape and the volatility emanating from that, but also the key thematics playing out in the market.

In today’s highly volatile market, building a growth portfolio can be a challenge, even for the most seasoned planner. But it is possible, says BlackRock product strategist, Simon Rafferty, who points to manager flexibility being the key for driving returns.

Speaking at the recent BlackRock Symposium, Rafferty says that from a portfolio construction perspective, the world is long-risk because investors have piled into the riskier parts of fixed income, and more recently, bond proxies.

“So, when we go through any episodic volatility, like we had in Q1 of 2016 and Q3 of 2015, investors panic sell, which exacerbates this volatility,” Rafferty says.

“That’s why, when building an investment portfolio, investors need to be mindful, not just of the macro landscape, but of market volatility emanating from that.”

So, how do you provide a natural counterweight to volatility, whilst providing cyclicality in your portfolio, knowing that certain asset classes, like bonds, are no longer performing in the way they have done so previously?

Rafferty admits it’s difficult, saying that it really comes down to investors giving their managers greater flexibility with their investment decision-making. “And that’s where active management comes in,” he says.

“We believe that at this point in the market cycle, where bonds are no longer performing the roll they have for the past few decades, investors may want to consider a broader opportunity set that comes with active management of their portfolio,” he says.

Rafferty believes that by allowing a manager to be more dynamic, investors can benefit by:

• Greater breadth of exposures – the ability of the manager to invest in traditional and difficult to access asset classes, regions, currencies, sectors and securities;
• Exposure to complex strategies – the ability of the manager to implement hedging (FX, credit, duration, equity beta), fixed income curve trades (steepeners, flatteners, forward markets), interest rate swaps and short sales; and
• The flexibility to trade in real time – the ability to rebalance a portfolio to capitalise on security price changes.

This flexibility also enables active managers to better understand and respond to key thematics playing out in the market, which Rafferty says is another important factor to consider when building a growth portfolio. He identifies five current themes as being:

1. Equities over fixed income

Rafferty prefers stocks to bonds. He believes that better value still remains with stocks than developed market government bonds. Dividend yields are attractive in several equity markets, especially in Europe, relative to sovereign bond yields. “We also believe that as major central bank policies shift, this will increasingly become an important factor to consider in asset allocation and currency management decisions,” Rafferty says.

2. Select opportunities in fixed income

Rafferty believes that developed market government bond yields are generally too low to meet most investors’ long-term return goals. However, opportunities do exist within investment grade, high yield and emerging markets. In addition, low breakeven inflation rates make US Treasury Inflation-Protected Securities an attractive alternative to treasuries.

3. Foreign exchange risk is elevated

Rafferty says that rising divergence in monetary policy, interest rates, inflation, capital flows and trade balances may lead to greater movement in foreign exchange rates.

4. Japanese and European equities over US and ‘broad emerging markets’

Rafferty favours Japanese equities, given their valuations, policy catalysts and corporate governance initiatives. He also believes European equities offer value and the opportunity for cyclical and profit margin recovery. “Yet, despite a challenging market environment, we believe select opportunities still exist within emerging market equities,” Rafferty adds.

5. Commodity-related and cash equivalents

Rafferty believes that both gold and cash has its place in an investment portfolio. Gold provides a hedge against debt monetisation and may see increased demand in low yield and volatile markets, such as Europe and China. Whereas cash helps mitigate volatility, is uncorrelated to other asset classes, and provides additional flexibility in adjusting portfolio risk.

So, from a portfolio construction perspective, how is Rafferty using market volatility and these key themes to build a growth portfolio?

“With the BlackRock Global Allocation Fund (Australia), at 56 per cent, we’re a little underweight equities, but at 27 per cent, we’re underweight fixed income and very underweight bonds,” he says.

“We’re underweight stocks because parts of the equity market that we like, tend to be more cyclical and volatile. In recognition of our promise to clients to provide them with a moderate risk profile, we have a less aggressive setting in stocks.”

In contrast, Rafferty is 4 per cent overweight in commodity-related assets, such as precious metals ETFs, and 13 per cent overweight in cash.

“Equities and fixed income are both probably the most polarising asset classes in the market. Gold has no cashflow. But in a world where you struggle to find negative covariance assets to equities, gold and Yen are the last two places you can find that. That’s why we have 9 per cent Yen in the portfolio and about 9 per cent in Japanese stocks.”

Rafferty adds that cash is also uncorrelated with stocks and bonds, which he says is important, as it provides BlackRock with a source of liquidity to put into the market during periods of dislocation.

“By providing a manager with flexibility, it means we can wait for a more attractive entry point, and then we’ll deploy that capital. That’s how we like to invest.”