By Ryan P. Blute, Head of Global Wealth Management, Europe, PIMCO.

PIMCO’s European global wealth management team recently surveyed financial intermediary clients across Europe. Drawing on the responses of 70 investors, including advisors, fund buyers and researchers, we can identify four themes as top-of-mind in 2018.

Ryan P. Blute, Head of Global Wealth Management, Europe, PIMCO

Maintaining flexibility

With stock markets at record highs, bond yields still near historic lows, and a global economy that may reach peak growth in 2018, it is little surprise that the biggest concerns identified by clients are high valuations followed closely by evolving monetary policy. As a result, clients say they are planning to increase allocations to flexible investment approaches, including absolute return-oriented fixed income and dynamic multi-asset strategies.

This desire for flexibility is consistent with PIMCO’s outlook that despite “Goldilocks” conditions of synchronized growth and low inflation, investors should start preparing for the risks that lie ahead.  Across all our portfolios we’re focusing on diversified sources of return without relying on one sector or beta, while maintaining flexibility and liquidity. And to maintain the most flexibility, we’d agree that strategies untethered to traditional market benchmarks may be an attractive option.

Reducing portfolio risk

While some investors may be content to retain current levels of risk in a more flexible structure, we find that others are looking to actively reduce portfolio risk. However, our own discussions centred on the challenges of doing this in an environment of zero or negative real returns on cash.

We can identify two potential solutions: Low volatility absolute return strategies, which offer many of the features of traditional cash products for those willing to assume moderately more risk, and core bond strategies, particularly those focused on the U.S.

Of these two approaches, increasing core bond exposure is the more contrarian view; many clients say they plan to decrease allocations in the coming year. However, core bonds can play an important diversification role in a portfolio, and U.S. Treasuries in particular remain a source of high quality duration, historically outperforming when there are significant declines in equity or credit markets. And since U.S. yields are starting at a higher point than European equivalents (e.g., bunds, gilts), U.S. core strategies should have more scope to outperform in a risk-market sell-off.

Diversifying credit exposure

At a sector-specific level, valuation concerns and de-risking intentions are also evident: Many clients plan to reduce allocations to investment grade credit, high yield and emerging markets. Yet, with credit still one of the few sources of yield, investors seeking to generate income have few options.

One potential solution is U.S. mortgage-backed securities (MBS), an area often overlooked by European investors but one that can provide diversification to traditional corporate credit and add yield to a portfolio. Agency MBS, high quality securities supported by the U.S. housing agencies, have generally cheapened over the last two years, in contrast to other credit markets, while non-agency MBS are generally benefitting from improving credit quality and the recovery in U.S. housing prices.

Finding alternatives to active equities

Outside of fixed income, the theme we see is the challenge of generating consistent alpha in equities. This is a valid concern based on PIMCO’s research (see “Bonds Are Different: Active versus Passive Management in 12 Points”).

Although many investors have responded by rotating from active to passive equity strategies, we think portable alpha strategies potentially offer the best of both worlds – passive exposure to equities with the potential to generate alpha from an actively managed bond portfolio. PIMCO has been managing these types of strategies for over 30 years, and they have demonstrated the potential to deliver consistent alpha across a range of market environments.

(The views expressed here are those of the author and do not necessarily reflect those of ETF Strategy.)