Abstract: While the COVID-19 has brought significant impact on social and economic development, it is also reshaping the asset allocation industry. Changes include: passive investment will become mainstream; active management strategy is not necessarily active; AI-driven investment will grow more popular; the share of alternative investment will increase; the concept of value investment will be challenged; the performance of pro-cyclical assets will be weak; gold might not be effective to offset the impact of excessive money supply; investors make profit from price differences of bonds and dividend differences of stocks; the rise of intangible assets will reshape investment models.
I. A macroeconomic environment where only change is constant
Since the outbreak of the COVID-19, profound changes have taken place in economies and societies. The only thing that does not change is change itself. It is still uncertain as to how the global pandemic will evolve in the time to come, and when it will come to an end.
Economic performance is not determined by economic factors
The macro environment we find ourselves in currently is unusual, and economic performance is no longer determined by economic factors. It is generally believed that economic crises have their own patterns and characteristics, and we tend to repeat the mistakes made in previous crises. But this time is different. When we talk about economic growth and economic performance next year, the implicit assumption is the successful control of the pandemic and the availability of vaccines, which has now become a “first principle” issue. Economic development and GDP growth comes only secondary. The fact that economic prediction is based on non-economic event is quite rare in human history.
Continuous attention needs to be paid as to whether the COVID-19 pandemic can be effectively managed in a relatively controlled time period and whether the forecast of economic performance could rely on economic factors again. At present, GDP growth is highly correlated with the number of confirmed cases. Only substantial progress in medical development and public health management will determine the trajectory of economic development post COVID-19.
Governments’ reflexive crisis response could produce a multiplied effect
Starting in 2008, or even 1997, governments have wielded their visible hands in the market whenever there was a crisis and have become conditioned to such practices. Just like people taking too many pills when sick, many governments overreacted since the outbreak of the COVID-19. They introduced more measures than needed to mitigate the impact of the pandemic, thus creating a compounded effect. In countries like the US, the UK, and Japan, the interaction between monetary and fiscal responses to the pandemic resulted in a multiplied effect.
This has been reflected in the reaction of the capital markets. For example, Spanish bond yield fell from 0.631 in March to -0.314 on October 15. The negative yield means investors have to pay for the right to purchase the Spanish bond. This is an extreme market reaction caused by policy overdose. Before the outbreak, borrowing costs in Italy were high, but by October 15, the yield on Italian bonds had dropped to 0.06, close to zero, indicating that the cost to address its liquidity problem was quite low.
Divergence in world economy is noticeable
The divergence in world economy is noticeable, especially in the capital markets of major economies. It is also the case in emerging economies. When we invest in and trade assets of emerging economies, they are generally managed as a cluster. For example, when we manage ETFs or portfolios of emerging markets, we do not see too much difference among Turkey, South Africa, Brazil and Indonesia. But the performances of emerging economies have diverged since this crisis (or since 2008), and the divergence has been accelerating since the outbreak. As different countries have different management models, their economic performances also differ, and the performance of capital markets will further divide.
So it would be wise to conduct careful analysis on each single country when investing in emerging market assets.
Global economic flows are showing signs of ebbing, and globalization in the traditional sense has reached plateau to some extent.
Many people criticize globalization for exacerbating the wealth gap and social inequality. But fundamentally, globalization is all about production and wealth creation based on comparative advantages, rather than wealth distribution and social equity. Therefore, we should not expect to use globalization in the traditional sense to address social equity.
Whether "globalization 2.0" can effectively balance wealth creation and social equity is another question. Just as we cannot expect cars to solve the problems that should be addressed by airplanes, or old phones to solve the problems that should be resolved by smartphones. At present, the growth rates of world trade and FDI are decreasing, and the flow of factors of production is showing a trend of ebbing. This trend is likely to continue for some time, especially given the global anti-globalization political sentiment.
Sustainable development issues like climate change and ESG have gradually become the bottleneck of the growth of new economy
Sustainable development is both a bottleneck and an opportunity. Once the bottleneck is broken, the transition of economic paradigms should be realized. The transition itself will bring a host of new opportunities, based not only on technological innovation but also on the reshaping of economic and social structures. These changes will profoundly shape our judgment of the future. In the US, China and throughout the world, ESG indexes have been continuously rising, as these issues are gaining increasing attention from economic and investment sectors which have been translated into actual investment behavior, rather than remaining a simple concept. Investment related to sustainable development can even bring above-average returns.
II. Asset allocation: nothing remains unchanged forever
1. Passive investment is becoming increasingly trendy
With the rise of passive investment, will the increase in programmed trading and ETFs disrupt the capital market and shareholder activism? Active shareholders can get involved in the management of a company and exert their influence through voting rights. ETF, on the other hand, is a passive approach to asset allocation and does not pay too much attention to how the firm is run.
In addition to alternative investments, other types of passively managed products account for nearly 40% of total investments, a considerable proportion. In addition, the boundary between absolute passive management and absolute active management is becoming increasingly blurred, making it difficult to determine which investment strategy is 100 percent active and which passive. Taking these factors into account, the actual proportion of passive investment may be higher than suggested by statistics. It is expected that by 2024, the proportion of passive investment will move towards 50%, which is an important structural change that will reshape open market investment and private investment in public equity (PIPE). Such a structural characteristic will definitely influence people's trading behaviors.
2. “Active management” is not necessarily active
“Active management” is not necessarily active. In some cases, the so-called actively managed funds charge management fees, while conducting passive management in practice.
Globally, index funds charge a management fee of 1.5% and 20% for excess return. However, in fact, managers only passively allocate assets, for instance closet indexers who follow relevant indexes but do not really make active investment. Such index funds account for a fair proportion in the global market. A comparison between FTEC funds and S&P 500 shows that FTEC funds perform well, but it is actually managed passively and only statistically counted as an actively managed portfolio. Such trend is also evident internationally. It is necessary to see whether the management fee charged is appropriate when making investment.
3. High-frequency trading, quantitative investment and even AI-driven investment will become mainstream
At present, high-frequency trading (HFT) and quantitative investment is becoming increasingly popular, accounting for an increasing share in the market. In the US, especially in the open market and secondary market, the share of quantitative and HFT is close to 60% or even higher. One set of statistics shows that it has reached three quarters. This ratio has significance because it is a mean, and sometimes means can hide important details. In opening and closing hours, the share is much larger, even reaching a dominant proportion. Clearly, HFT and quantitative investment have not only become mainstream, to some extent, they are also playing a decisive role in investment. It is still hard to predict what impact they will have on the market in the future.
Algorithms are black boxes. Whatever happens inside an algorithm is only known to the organization that uses it. It is difficult to know the differences between different algorithms. The risk caused by algorithmic trading would be a systematic one because it can create self-reinforcing trends and cause chain reactions. Once an algorithmic error occurs, the potential harm is systemic rather than isolated. At present, financial regulators have already taken note of the fast rise of quantitative and high-frequency trading. More attention should be paid to the systemic risks that may be caused by algorithms.
Currently, the performance of AI investment is better than other strategies. In some scenarios, AI investment has outperformed traditional quantitative trading and general hedging strategies. AI may have captured the nature of investment to some extent. We are not absolutely sure that AI has understood the rules of investment, but at least it can compete with traditional investment and is not just a supplement to mainstream investment strategies.
4. Alternative investments are no longer “alternative”
In the past, alternative investments were investments made to balance the portfolio when making mainstream investments. But now, many alternative investments are no longer "alternative", they have become the "main dishes", bread and butter.
The inclusion of private equity funds in the investment portfolio is close to 58%, and hedge funds 55%. Real estate, infrastructure, private equity, natural resources, agricultural land and other related investments have entered mainstream investors’ portfolios. When mainstream investors make investments, they first consider the secondary market which features higher liquidity. However, they will also turn to the primary market and PIPE, and make alternative investments. This is because it is difficult to achieve high yields in the secondary market and charge higher management fees. Without high management fees, investors cannot stand out in competitions. Therefore, alternative investments have become a natural choice. It is no longer "alternative" but has gradually become a mainstream investment strategy.
5. The distinction between value stocks and growth stocks in open market investment is becoming more and more blurred, and the concept of pure value investment is severely challenged
The theoretical basis of value investing is to look for stocks that are undervalued. Looking back, another theoretical basis is information asymmetry. Due to the asymmetry of information, investors can ferry out undervalued stocks and then make value investment. But now that data is widely interconnected, people can access all kinds of data in various fields such as economy, society, ecology, culture, and politics, and transform them into valuation factors through algorithms and models. In this case, it is very difficult to find relatively undervalued stocks. In the next step, the concept and rules of value investment may need to be adjusted to a certain extent.
Now, value stocks have become high-quality stocks, meaning that the companies themselves have value. But value stocks need to have growth potential, this is part of their quality. Growth and value are now closely connected. There won’t be any value without growth. In the past, stock value was estimated based on a company’s profitability, but in the future it will be based on the company’s valuation, which will be decided by expectations. Expectations mainly depend on technological innovation. Factors such as business models can also make a difference. The above changes require investors to change their investment thinking and philosophy.
6. Pro-cyclical assets such as bulk commodities have weak performance
When the economic cycle is about to enter a different stage, pro-cyclical assets often perform poorly. We are now facing a turning point in the energy revolution, and the performance of fossil fuels such as oil, coal and other traditional commodities are lackluster. We don't know whether people will find new energy and new bulk commodities. However, if there are any, they may be able to lead the bulk commodity market back on the rising track, ushering in another cycle. This will require technological breakthroughs and changes in consumer behavior.
7. Two major financial attributes of gold: safe haven versus value preservation
Gold often serves as a safe haven asset, but its function of value preservation is not sufficient or significant. Many people believe that gold can maintain its value, and indeed the price of gold has risen periodically after the outbreak of the pandemic. However, gold can only preserve value when the interest rate is extremely low. Why can gold act as a hedge? Markets do not believe that the Federal Reserve and central banks will control the speed of money printing, but they believe gold can function as a safety cushion since gold reserves are limited. However, massive empirical studies have shown that the value preservation function of gold is not significant.
8. Stock investing seeks interest spread while bond investing seeks price spread
In the past, investing in bonds was synonymous with conservative and prudent behavior. Now the issuance of high-yield bonds has increased, and high-yield bonds and junk bonds are frequently traded, a big change from the old days. Stock investing began to seek interest spread while bond investing price spread.
The reason for this peculiar trend is that with 14 trillion dollar bonds having negative interest rates, investors can only pursue price spread; meanwhile, as the valuation of technology stocks is high, investors are worried that they might buy the stocks at their highest prices, so they would add stocks with higher dividend in the portfolio. Currently the dividend stock index is in a rally, and the situation in China is the same. The CSI high dividend yield market is also performing well. It can be seen that at least some stock investors value dividend spreads more than price spreads.
9. The growth of intangible assets changes investment patterns
One of the important changes in the economy and the market is that the growth of intangible assets is changing the way we invest. Research shows that during the 2008 financial crisis, intangible assets accounted for 84% of the market value of the S&P 500. The real economy in the US is sluggish, why is the stock market doing so good? The concept of the real economy is no longer robust, and the real value of the real economy lies in the creation of intangible assets. The virtual part rather than the physical part ultimately determines economic performance. In the future, the scope of the traditional real economy will only become smaller, and whether it can reflect the contours of the economy as before still needs further systematic research.
The increase in the proportion of intangible assets has changed the internal structure of the economy, and this change will have an impact on investment behavior. For example, new issuance methods such as direct listing that does not require investment banks as intermediaries, and new investment vehicles such as special purpose acquisitions companies (SPACs). SPACs are listed on the public market, and does not disclose any investment targets. After investors provide funds, SPACs would search for and arranges suitable investment targets, especially technology stocks.
Recently, secondary funds in the private equity market have boomed. In addition, their volatility presents a phased characteristic. Rather than maintaining a trend up or down, it is highly correlated with influential events, presenting sudden rises and falls.
III. Investment methods are diversified and investment favors China
First, stocks and bonds are expensive. The increased debt, liquidity, and asset inflation have all boosted stock and bond prices. At present, the global stock and bond markets are at high levels.
Second, people have concerns. The first concern is whether the quantitative easing adopted by central banks in various countries is sufficient. The second is when and how the quantitative easing and unconventional monetary policies will exit?
Last, asset sectors are seeing accelerated changes. Except for technology stocks, other sectors are going through a difficult time, so diversified investment is recommended. China is a top investment destination. The investment targets in the Chinese market, including high-rated bonds, provide a certain level of stable yield and have the function of a safety cushion, which can attract smart money and long-term investment in the long run. At the same time, the stability of China's capital market, especially the high stability of yields on investment products, will increase the attractiveness of RMB assets and facilitate RMB internationalization.
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