Protecting against risks: This is how investors improve their risk/return profile

The threat of a trade war, turmoil in Italy, and monetary policy normalization have led to concern in the financial markets. So what are the main sources of concern and how can investors best protect themselves against them without having to change their investment strategy fundamentally.

Hedge against risks

This year has been challenging for investors, with monetary policy normalization, fears of a trade war, geopolitical tensions and renewed fears in Europe impacting sentiment. In spite of all these, the global economy is growing above trend and equity market returns have been oscillating around zero to slightly positive, suggesting that markets have strong fundamental support.

Although we remain confident in our balanced but risk-on stance, several areas of concern are risks. These risks can be hedged without having to change the investment strategy fundamentally. The objective is to, at worst, bear moderate costs, but achieve sizable returns if a risk case materializes so the overall portfolio is stabilized.

Investment ideas in view of geopolitical tensions

The dispute between the USA and its key trading partners has caused much market volatility and is likely to remain a concern for investors. Positions like long JPY, long Australian government bonds (currency hedged) or long US small versus large cap stocks would likely do well if trade concerns worsen.

Geopolitical tensions have flared up periodically in recent months, with the Middle East in particular garnering attention and pushing up the oil price. While an escalation remains a risk, there is little incentive for renewed confrontation. With OPEC looking to stabilize the oil price, we believe that risks are somewhat balanced for oil going forward. Still, energy stocks are a nice hedge to any renewed flare-up and are attractively priced.

We are sticking to our tactical focus on riskier investments.

Matthew Lehmann, Head Multi Asset Strategy

Hedge risks posed by Italy and euro zone

Euroskeptic parties reaching power in Italy has led to a sharp sell-off in Italian assets and some contagion to other European peripheral bond markets. But it is unlikely that Italy really intends to leave the euro zone, and so it does not present a systemic risk. Still, the market will require a higher risk premium on Italian assets than before.

The most attractive hedge for this is to buy US Treasuries (UST) against Italian government bonds (BTPs), currency unhedged. UST yields are above those of BTPs and will likely rally strongly if this or any other risk we discuss here becomes systemic.

Hedging pays off if one of these risks actually materializes.

Matthew Lehmann, Head Multi Asset Strategy

Investment ideas based on central bank policy

Global economic growth has improved considerably and become more synchronized, offering central banks an opportunity to unwind their quantitative easing (QE) programs and begin normalizing policy. Although QE is often credited for the rise in risky asset prices in recent years, the end of QE is not a reason to be concerned about the economic cycle or equity markets.

Yet, to hedge against this risk, investors might consider owning long-duration government bonds in high-yielding developed economies such as Australia (currency hedged) and the USA (currency unhedged). If tighter financial conditions start to hurt growth, central banks would likely reverse course and may even start cutting rates.

Improving the risk/return profile

We remain comfortable with our positive growth view and risk-on stance, but ideas like the ones just described should not lose much money and do well if any of these risks materialized. Thus they can improve the risk/return profile of portfolios.