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###### Fullerton Market Update - April 2025


#### Executive Summary:

•	China properties used to dominate the issuance action and broader direction of the Asian Fixed Income (AFI) markets, but this is no longer the case. 

•	The sector now comprises a much smaller fraction of the wider AFI universe. 

•	Single-sector overdependence and index sector concentration was an issue historically -leading to weak diversification and vulnerability in downturns. 

•	The income attraction of Chinese properties as a standalone sector has declined. 

•	To build sustainable income streams in AFI portfolios going forward, investors need to re-imagine their approach to this universe. 

•	A diversified portfolio of various fixed income sub-segments and income generation sources (organised along their income generation profile and capacity) may be the “way to go”. 

•	This can be executed via a flexible, best ideas, multi-specialists, team-based approach for opportunities across the economic cycle. 
 

#### How will the Asian Fixed Income markets reemerge from the shadow of the Chinese property sector meltdown?


##### Background

Prior to 2020, Chinese properties were a large part of the Asian Fixed Income (AFI) and Asian High Yield (AHY) universe. They dominated the issuance action and drove the wider direction of the AFI markets. As of December 31, 2019, China credits and Chinese property constituted c. 54% and 37% of the JACI Non-Investment Grade Index¹ respectively. Moreover, its high yield nature was appealing to Asian fixed income investors seeking regular and high-income payouts at that point, the concentrated country and sectorial exposure notwithstanding.

All this changed abruptly in 2020 with the rollout of the “three red lines” policy that was intended to address excessive leverage in China’s property developers. The heightened regulatory posture was in-line with what would later be known as the government’s “common prosperity” drive, and this expanded to other areas like tech and education.

The increased scrutiny led to tightening credit conditions within property developers, mounting liquidity issues, halted construction projects, weaker home pre-sales, mortgage boycotts, delayed home deliveries, and a general weakening of sentiment towards the sector. Reports of rating downgrades, and credit defaults intensified, impacting even the larger property developers and State-owned related names.

Measures were subsequently introduced to stabilise the market, such as reducing mortgage rates and easing of home purchase restrictions, but investor confidence had already eroded. With the onshore and offshore funding channels narrowing or even closed, this sector has since become a smaller part of the wider AFI universe, impacting investors behaviour towards this market in the process.

Today, as of 19th February 2025, China credits and Chinese property names constitute c. 22% and 7% of the JACI Non-Investment Grade Index² respectively, a significant decline from its heydays.
 
## Implications and lessons learnt from China’s property sector consolidation


China’s policymakers increased scrutiny on the real estate sector was meant to be a balancing act aimed at managing systemic risk, while also upholding measures to ensure the long-term health of the property market and housing affordability.

While its resolve to execute structural reforms to pivot away from an over-reliance on this credit-intensive sector should not be underestimated, investors may have underappreciated the far-reaching consequences of the prolonged correction in the housing market, on both the wider economy and financial stability. The impact of the correction has extended to related upstream and downstream sectors as well - such as furniture companies and construction entities. This ripple effect has further dampened private sector confidence. Additionally, the negative wealth effect stemming from weak property sales and declining property prices has created a negative feedback loop, weighing on China's domestic consumption and reinforcing deflationary pressures.

Another lesson gleaned from the Chinese property saga is the overdependence on Chinese property developers for yields. The tumultuous period since 2021 underscores the issue of sector index concentration risk, which has accumulated over time. With the downturn and high concentration risk in the sector, this has led to many investors in this space underperforming. The experience from this episode highlights the need for investors to diversify – even amidst a backdrop of ultra-low interest rates, where the inclination to chase higher income and yields were very high.

The home and cultural biases of Asian fixed income investors was also evident, in that investors in this space were to some extent coloured by China's then robust growth figures, which disproportionately directed them to favour Chinese property bonds. This led to significant issues when the sector underwent a downturn.
 
## What’s next – how should investors re-imagine their investing approach to the AFI and AHY universe?
With Chinese properties no longer being the cornerstone for high-yield bond issuance in the AFI market, we must confront the new reality that the income attraction of this space as a standalone has receded. Investors who used to access this space for its high-income potential may need to reevaluate their approach.

How should one construct an Asian credit portfolio that is still high-income oriented? First, it is critical to recognise that the Asian credit and AHY markets have irretrievably changed. Excluding China property, the AHY index currently has sector concentration in Macau gaming (at 10%) and Indian renewables and commodities (at 9%)³ . Although the weightings are lower than what China Real Estate’s weight was during its peak, the current opportunity set is not sufficient to build a sufficiently diversified AHY portfolio.

In our view, we need to spread our risks over multiple fixed income segments and functional buckets (organised along their income generation potential capacity) – i.e. one bucket that classifies instruments by their ability to generate consistent and stable income (Income Stabilisers); another that groups income-paying securities by their low correlation traits (Income Diversifiers); and another bucket which comprises of high-conviction income-paying securities (Income Generators). The approach is then to adopt a conscious high income-oriented mindset via allocation across these functional buckets by considering each bucket’s income contribution attributes on its own merits, and how it can complement the wider portfolio. This can be executed via a flexible, best ideas, multi-specialists, team-based approach. This way, one may potentially build a high-income paying portfolio that is diversified across multiple income streams, and not disproportionately reliant on one sector.

Over a cycle, we believe this approach of diversifying income generation sources, should outperform an investing method that is concentrated in HY assets. This approach has the added benefit of tapping into different economic cycles and opportunities. The adoption of a team-based decision-making processes further strengthens and enhances the final outcome. A diverse team provides a variety of perspectives, challenges the status quo and reduces individual biases. This approach leads to more balanced decision-making framework, reducing the impact of overconfidence and heuristic biases. Relative to a concentrated HY approach, global diversification with an Asia core as a focus will be key.
 

¹ Source: JP Morgan Asia Credit Index (JACI), December 2019 
² Source: JP Morgan Asia Credit Index (JACI), February 2025 
³ Source: JP Morgan Asia Credit Index (JACI), 19 February 2025 

 
Important Information

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The changing face of Asian Fixed Income investing

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**Author: Michael Sun**
**Director of Quant Capability, Eastspring Singapore**

**Executive Summary**

•	**Tariffs and rising protectionism have increased policy uncertainty, highlighting the need for defensive investment strategies**

•	**A low volatility strategy has shown resilience during market turbulence, protecting against downside risks**

•	**Active bets allow investors to capitalise on the market’s nature to distinguish between winners and losers during selloffs**

Recent tariffs, rising protectionism, and an uncertain inflation outlook all reflect the heightened policy uncertainty, as illustrated by the Economic Policy Uncertainty (EPU) Index. This index measures the frequency of articles in newspapers that contain terms related to economy, policy, and uncertainty, reflecting the growing concerns among businesses and investors. Interestingly, there is a notable disconnect between this uncertainty and financial market volatility. See Fig 1. 

While there might be various reasons contributing to this, i.e. some investors still being in the “it’s just a negotiating strategy” camp or the market’s perception of Trump’s growth-friendly policies offsetting volatility, the fact remains that Trump's "weaponisation of uncertainty" has been dialled up in his second term. There is no doubt that the pain from tariffs will trigger a chain reaction at both the macroeconomic and corporate levels. Market volatility is thus likely to be a constant feature. 


#### Fig 1: The disconnect between uncertainty and financial market volatility

![Draft 3-Tariff Turbulence short paper.fig 1.jpg](/uploads/Draft_3_Tariff_Turbulence_short_paper_fig_1_fd188ba64d.jpg)
###### Source: Bloomberg, Economic Policy Uncertainty, and Eastspring Investments, Feb 2025

Economists at Goldman Sachs have estimated that across-the-board tariffs on Canada and Mexico would result in a 0.7% increase in core inflation and a 0.4% reduction in gross domestic product¹ . The potential to drive up consumer prices is particularly concerning for investors, who fear a resurgence in inflation could prompt the US Federal Reserve (Fed) to halt its rate-cutting measures. As expected, the Fed paused its rate-cutting cycle in March, with Chair Powell stating that officials were 'waiting to see what policies are enacted' under the new president. 

## Enhancing portfolio resilience is key

To ensure resilience in an unpredictable economic environment, investors should diversify their investments and modify their portfolios to be more defensive. For example, adding a low volatility (low vol) strategy can enhance the defensiveness of an overall investment portfolio. A defensive portfolio typically aims to limit losses during market selloffs. 

To understand it better, let’s look at how a low volatility style, using the MSCI AC Asia Pacific ex Japan Minimum Volatility index as a proxy, reacted during President Trump’s first term in office, when the administration imposed tariffs in 2018. Between Mar 2018 and Dec 2018, both the US and China engaged in a tit-for-tat move by imposing tariffs on a wide range of goods. 

The imposition of tariffs on a wide range of goods led to increased uncertainty and volatility in the markets. Equity markets directly linked to the trade war experienced notable declines, particularly in the latter half of the year. See Fig 2. In contrast, the Asian low vol index provided downside protection and delivered resilient performance throughout this period. 

#### Fig 2: Impact of tariffs during the 2018 US-China trade war

![Draft 3-Tariff Turbulence short paper.fig 2.jpg](/uploads/Draft_3_Tariff_Turbulence_short_paper_fig_2_5c6bcc7fe5.jpg)
###### Source: Source: LSEG DataStream, MSCI, S&P, Eastspring Investments, Feb 2025

## A low vol strategy is inherently defensive  

Given the evolving global economic landscape, we conducted a stress test to evaluate the potential impact of tariffs on a low vol portfolio. We utilised the Aladdin risk management systems' Global Trade Protectionism scenario, to assess the impact of significant tariffs on global trade, inflation, interest rates, including retaliatory actions from affected countries. The test assumes that additional tariffs will result in higher domestic inflation, leading to increased interest rates and a stronger dollar, and considers potential selloffs in US companies which have supply chains heavily dependent on non-US inputs.

The results suggest that a low vol defensive style continues to protect the downside and deliver approximately 3% excess performance due to its defensive positions. See Fig 3. That said, we are fully aware that markets are forward-looking, and the macroeconomic and market impact from the Trump administration are likely to change from time to time. 

#### Fig 3: Profit and loss impact from global trade protectionism 

![Draft 3-Tariff Turbulence short paper.fig 3.jpg](/uploads/Draft_3_Tariff_Turbulence_short_paper_fig_3_499dc84b79.jpg)

###### Source: BlackRock Aladdin, Eastspring Investments. Low vol style based on Min Vol Index, Feb 2025

## Active bets can help navigate idiosyncratic risks

Besides policy uncertainty, markets have also been rattled by the sudden emergence of China's DeepSeek Artificial Intelligence (AI) model with technology stocks impacted the most. When the news broke on Jan 27th, the Nasdaq 100 index tumbled by 3% while Nvidia experienced a sharp drawdown of 17%, one of the largest losses in market history. This event is a black swan for the AI industry, as DeepSeek's open-source model presents a direct challenge to proprietary AI offerings from US-dominated major players like Google (Gemini) and Microsoft (OpenAI). 

Apart from its disruptive nature to the AI industry, this idiosyncratic event ironically highlights the need for diversification. Despite the overall decline in major market indices, under the surface, 351 stocks within the S&P 500, or approximately 70% of the constituents, ended the day higher. This is the highest number of stocks delivering positive performance when the overall market, as measured by the S&P 500, declined more than 1% since 2000. It was unprecedented over the past 25 years!

This type of price action further emphasises the importance of having a diversified portfolio. Making active bets across more than 350 positions allow investors to benefit from the fact that the selloff has not been indiscriminate, with markets distinguishing between winners and losers. Furthermore, a portfolio that diversified across sectors, countries, and importantly, investment styles, can ultimately deliver a resilient performance. Enhancing portfolio buffers with low volatility equity strategies can help cushion against downside risks and contribute to more stable returns in 2025.


#### Fig 4: Number of stocks that outperformed in down markets  

![Draft 3-Tariff Turbulence short paper.fig 4.jpg](/uploads/Draft_3_Tariff_Turbulence_short_paper_fig_4_4f19ee41cc.jpg)
###### Source: Bloomberg, S&P and Eastspring Investments, Jan 2025


Staying steady in chaotic markets

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# Create a visual map of your financial future

Are you saving money without a clear purpose? And putting off investing because you don’t know where to start?

•	**Give meaning** to your investments by connecting them to your life goals.

•	**Break down your journey** into clear, manageable steps.

•	**Make decisions** that align with what matters to you.

Ready to take the first step?

**[Define your goals](https://www.amundi.com.sg/retail/new-investing-start-here-step-step-guide)**
 
# Wondering which investments actually match your goals?

With countless investment options available, choosing the **right** ones can feel challenging. Investment decisions deserve careful thought.

We cut through the complexity and help you **match investments** to your goals.

Let's clear the path to your investment decisions.
 
# Understand the risk-return connection

![image1.jpg](/uploads/image1_fc61fa6d81.jpg)
 
# Factor timelines in your decision

Your investment horizon significantly influences which solutions make sense for you:

![long-terms-shorts-term.png](/uploads/long_terms_shorts_term_1449ede84d.png)

### Diversify your investments

![image2.jpg](/uploads/image2_f259f8c12e.jpg)
 
# Evaluate different options

There are many options for how you can best build your portfolio:

![different-funds.png](/uploads/different_funds_fd7e1701a3.png)


# From Knowledge to Action

Investment knowledge is your foundation, but action is what builds your future.

These key principles help you better understand your options and have productive conversations with your financial advisor. Today's choices build tomorrow's success.

 

##### Important and Legal Information
This document is issued by Amundi Singapore Limited (Company Registration No. 198900774E) who is regulated by the Monetary Authority of Singapore. 

This document is for information purposes only, is not a recommendation, financial analysis or an investment advice and does not constitute a solicitation, invitation or offer to purchase or sell any product. The information contained in this document is intended for general circulation without taking into account the specific investment objectives, financial situation or particular needs of any particular person. 

The information contained in this document is as at February 2025 except where otherwise stated. The information contained in this document has been obtained from sources believed to be reliable but has not been independently verified, although Amundi and its affiliated companies (collectively “Amundi”) believe it to be fair and not misleading. Opinions expressed in this document are subject to change without notice. Amundi does not accept liability whatsoever whether direct or indirect that may arise from the use of information contained in this document. Amundi and its associates, directors, connected parties and/or employees may from time to time have interests and/or underwriting commitments in the securities mentioned in this document.

**Past performance and any forecasts made are not necessarily indicative of the future results**. Any forecast, projection or target is indicative only and is not guaranteed in any way. All investments involve risks and the amount received from such investments may be less than the original invested amount. Amundi does not guarantee that all risks associated to the securities mentioned herein have been identified, nor does it provide advice as to whether you should enter into any transaction.

This document is solely for issue in permitted jurisdictions and to persons who may receive it without breaching applicable legal or regulatory requirements. The information contained in this document shall not, without prior written approval of Amundi Singapore Limited, be copied, reproduced, modified, or distributed, to any third person or entity in any country.
This document is not for distribution and does not constitute an offer to sell or the solicitation of any offer to buy any securities or services in the United States or in any of its territories or possessions subject to its jurisdiction to or for the benefit of any U.S. Person (as this term is defined in SEC Regulation S under the U.S. Securities Act of 1933). 

**This document has not been reviewed by the Monetary Authority of Singapore.**

How can Goal-Based Investing help you with retirement?

How To Build Wealth ft. Earn Your Leisure

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*By Chris Hay, Vice President, Sustainability Solutions, BlueOnion*

### Introduction

Responsible investing is at a critical crossroads. The European Securities and Markets Authority (ESMA) recently revealed that over 40% of ESG-labeled investment funds in the EU may need to change names or sell assets to comply with new anti-greenwashing rules. 

Thousands of ESG-labeled funds are still invested in companies exceeding fossil fuel revenue thresholds. At the same time, hundreds more are exposed to controversial weapons, tobacco, and businesses that harm the world.

These findings underscore the urgent need for precisely classifying green financial products. Financial institutions risk losing investor trust, facing regulatory penalties, and failing to contribute to real sustainability progress without standardized criteria. Proper classification ensures that green-labeled funds align with ESG objectives, reinforcing credibility and investment transparency.

One of the most widely adopted frameworks for green classification is the EU Sustainable Finance Disclosure Regulation (SFDR), which categorizes funds into Article 6 (no sustainability focus), Article 8 (promoting ESG characteristics), and Article 9 (targeting measurable sustainability impact). Beyond classification, the rise of transition finance offers a new investment opportunity by supporting companies actively shifting toward greener business models rather than focusing only on already sustainable ones.

### Regulation as a driver

Regulatory compliance and transparency are central to classifying green financial products. The SFDR framework requires asset managers to disclose how sustainability risks are integrated into investment decisions. Without a transparent classification system, the market risks become fragmented, with inconsistent sustainability claims leading to investor confusion and regulatory scrutiny.

Beyond regulatory obligations, investor trust is at stake. Institutional and retail investors increasingly demand sustainable investment options with genuine ESG commitments. Misclassified funds that fail to meet these expectations can suffer reputational damage and potential legal consequences. Asset managers can reinforce credibility and attract responsible investors by ensuring that funds marketed as sustainable adhere to measurable ESG criteria.

Risk management also plays a crucial role in green product classification. The SFDR mandates that asset managers consider Principal Adverse Impact (PAI) indicators, which measure whether a fund’s investments cause significant harm to society or the environment. Under these guidelines, Article 8 funds must ensure that their investee companies avoid major ESG controversies, such as involvement in fossil fuels, weapons, or human rights violations, while maintaining a minimum ESG score. Article 9 funds face even stricter requirements, ensuring that at least half of their portfolio actively contributes to sustainability goals while doing no significant harm.

Studies have found that nearly half of ESG funds in the EU fail to meet Paris-Aligned Benchmark (PAB) exclusion criteria, with fossil fuel investments being the most common issue. Thousands of funds continue to invest in companies exceeding the 10% oil revenue limit, while hundreds of others are exposed to controversial weapons, tobacco, and high-emission energy generation. Financial institutions may unknowingly expose themselves to sustainability risks and non-compliance without proper classification.

### Greenwashing Mitigation

Greenwashing—where financial products misrepresent their ESG credentials—has emerged as one of the most significant threats to sustainable finance—asset managers who fail to back up sustainability claims with evidence risk regulatory scrutiny and damage investor confidence. Superficial ESG integration, misleading marketing claims, and a compliance-driven "box-ticking" approach undermine the industry's credibility and can lead to regulatory penalties.

Asset managers must adopt an evidence-based approach to sustainability classification to mitigate these risks. This requires going beyond basic ESG disclosures and conducting in-depth assessments of investee companies. A key aspect of this due diligence involves analyzing capital expenditures (CAPEX) and operational expenditures (OPEX) to determine whether companies genuinely invest in green initiatives rather than making superficial sustainability claims.

Ongoing monitoring is also critical in preventing greenwashing. A company that meets sustainability criteria today may not maintain those standards in the future. Regular reviews of investee companies ensure that funds remain aligned with their stated ESG objectives and do not become vulnerable to sustainability downgrades or reputational risks.

Stakeholder engagement further reinforces credibility in sustainable investing. Asset managers should actively engage with investee companies to ensure that they are not merely making sustainability commitments on paper but are taking concrete steps toward measurable improvements. This engagement can include setting specific ESG performance targets, participating in ESG-related shareholder resolutions, and collaborating with companies to refine sustainability strategies. Without active engagement, ESG commitments risk becoming empty promises rather than catalysts for real change.

### Turning Transition into Profits

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Traditional green investing has primarily focused on companies that already meet high ESG standards. However, transition finance presents a new opportunity by supporting businesses actively shifting toward greener practices. Many industries—particularly those in high-emission sectors such as energy and manufacturing—are undergoing significant transformations to align with sustainability goals. Instead of divesting from these industries altogether, asset managers can support and accelerate their transition.

Evaluating a company’s transition readiness requires a deeper level of analysis. Assessing where a company stands today is not enough; what matters is whether it has a credible plan to become more sustainable. This includes tracking science-based targets for carbon reduction, commitments to net-zero pathways, and improvements in PAI indicators over time.

For example, a European steel manufacturer, traditionally reliant on coal, has committed to net-zero emissions by 2040. Over the past three years, it has reallocated 30% of its CAPEX toward green hydrogen technology. Asset managers tracking CAPEX and OPEX shifts can verify real progress and differentiate between genuine transition leaders and companies making empty sustainability claims.

By incorporating finance into their sustainability strategies, banks, and asset managers can generate long-term value while driving real environmental and social progress. This approach expands the pool of investment opportunities beyond companies already ESG leaders, allowing financial institutions to play a more active role in shaping the sustainability landscape.

### Safeguarding Banks and Asset Managers Against Unintended Greenwashing

Companies such as BlueOnion specialize in detecting greenwashing risks and monitoring transition investments using an advanced data intelligence platform. 
Banks and asset managers can validate a fund's alignment against Article 8 and Article 9 metrics through an evidence-based SFDR classification methodology. The fund’s PAI scores also ensure that funds avoid significant ESG risks and meet sustainability criteria.

For asset managers financing transition trends, demonstrating that portfolio companies are making measurable, sustainable progress is crucial. Analyzing CAPEX, OPEX, and sustainability-linked revenues offers concrete evidence of a company's transition strategy. This approach strengthens the verification process and fosters active engagement with underperforming investees, enabling asset managers to encourage ESG improvements instead of resorting to premature divestment.

### The Best of Both Worlds:

As regulatory scrutiny of ESG investing intensifies, financial institutions face the dual challenge of ensuring compliance with evidence-based standards while maintaining investor trust and mitigating greenwashing risks. Yet, effective ESG classification goes beyond regulatory obligations—it unlocks opportunities in transition finance to support companies genuinely striving for sustainability.

Advanced ESG intelligence tools help asset managers address the challenges of regulatory compliance and sustainability integration. By utilizing real-time analytics, comprehensive ESG insights, and compliance support, these tools enable financial institutions to develop transparent, sustainable investment portfolios while contributing to long-term positive impacts across the financial sector.

#### [Discover how BlueOnion can be your partner to tackle greenwashing risks—request a demo today.](https://outlook.office.com/bookwithme/user/4aac47fbc3da42d9b66c839edcbe429d%40blueonion.today/meetingtype/s33aHo3azkGS0dCzQkbP-w2?anonymous)



ESG Under Fire: Unlocking Credibility with Green Classification

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CIO VIEWS. **Sonal Desai**, Ph.D. Chief Investment Officer, Franklin Templeton, Fixed Income

Two driving forces are now simultaneously pushing in the direction of higher long-term real interest rates. While investors and commentators often tend to conflate the two, I think it is useful instead to distinguish them clearly. They are rising investment, and persistently large fiscal deficits.

A new trend toward stronger investment has emerged and is likely to endure for the next several years, driven by a number of important priorities: (a) there is a need to make up for past under-investment in infrastructure, including traditional infrastructure as well as digital infrastructure. The American Society of Civil Engineers’ latest report assigns a failing grade to overall US infrastructure (not for the first time);¹ (b) rising geopolitical tensions necessitate an increase in defense spending across Western countries; (c) growing interest in the potential of Artificial Intelligence calls for new investment in the necessary hardware (notably semiconductors), software and energy; (d) the green energy transition requires more investment to boost the role of renewables; and (e) manufacturing companies need to continue to invest in new technologies, which includes making supply chains more resilient.

Not all of this will result in rapid gains in productivity. For example, while the green energy transition is a very important goal,
a lot of the required investment will not increase productivity growth in the short and medium run. Because it consists of replacing existing capital, it increases current economic growth via higher expenditures, but it does not raise productivity—much like rebuilding existing structures after they’ve been destroyed by a hurricane. The economist Jean Pisani-Ferry, in a recent report for the French government, has estimated that in fact investment in the green transition will likely reduce productivity growth by a quarter percentage point per year for the next several years. (The report also warns that the green transition increases inflation risks over the next decade).²

However, the bulk of investment should over time result in faster productivity growth (the acceleration in US productivity during 2023 already gives hope, even if the weak first quarter of this year counsels caution). Faster productivity growth should in turn drive faster real economic growth, reversing one of the key arguments of the Secular Stagnation theory,³ and implying a higher equilibrium interest rate in the long run.

Moreover, for a given level of savings, stronger investment also eliminates or reduces the “savings glut,” again pointing to higher real interest rates. The government has and will carry out some of this, and investment is therefore often mentioned in the same breath as wider fiscal deficits. But the two need not go hand in hand. Governments could offset stronger public investment with a reduction in less productive public spending (or with higher taxes). Moreover, a significant portion of governments’ investment often turns out to be ineffective at raising productivity—the private sector has consistently been a much better allocator of capital.

The United States has experienced a persistent loosening of fiscal policy that goes well beyond the country’s public investment efforts. Therefore, quite separately from lifting investment, persistent large fiscal deficits now play their own important role in shaping the outlook for interest rates. The US government has been running a massively loose fiscal policy for a very long time now: The US fiscal deficit has averaged close to 8% of gross domestic product (GDP) for the last six years. It averaged just under 6% of GDP during 2022-2023 even as economic growth boomed, and the Congressional Budget Office (CBO) projects the deficit to average 5.5% of GDP for the next five years and then to rise further into the future. As a consequence of persistent large deficits, the debt stock has risen sharply.

A decade ago, publicly held federal debt was about 70%; now it is close to 100% of GDP and will keep rising rapidly if deficits remain as large as the CBO forecasts.

The need to fund large fiscal deficits year after year means a lot of pressure on bond supply. For a given level of demand, this tends to push bond prices down and interest rates up. Moreover, a large fiscal deficit, growing debt and high interest rates create a vicious spiral that makes it harder and harder to reduce the deficit. Currently, non-defense discretionary expenditures account for less than one-sixth of the US budget (15% of total expenditures). Interest expenditures meanwhile keep rising—they averaged just 1.5 % of GDP in the last 10 years. The CBO projects that they will average 3.5 % of GDP for the next 10 years, more than double, and will grow larger than non-defense discretionary spending by 2025. This would leave very few resources for education, infrastructure investment, transportation, homeland security and the like.

And, the underlying CBO forecasts are probably conservative: They assume that the interest rate on federal debt will remain under 3.5% over the next decade. To put this assumption in perspective, consider that through the 1990s up to the eve of the global financial crisis (GFC)—in other words before the more recent period of ultra-loose monetary policy—the interest rate on US government debt averaged close to 6%. If the average interest rate on debt were to rise even just one percentage point above the CBO assumption (still well below the pre-GFC average), within 10 years interest expenditures would be more than double their current level.

Any way you cut it, bringing the US budget deficit under control will require very serious efforts, which in my view seems implausible in the current political climate. Meanwhile, loose fiscal policy will likely continue to put upward pressure on interest rates.

![graph.png](/uploads/graph_6d52968ef5.png)


I have been arguing for some time that equilibrium real interest rates are likely much higher than the markets and the Federal Reserve (Fed) still seem to assume—with the neutral fed funds rate above 4% rather than at the Fed’s current forecast of about 2.5%, and 10-year US Treasury yields correspondingly higher. The confluence of loose fiscal policy and a rising investment trend can only strengthen my conviction in this higher interest rates outlook.


[1] Source: “2021 Report Card for America’s Infrastructure.” American Society of Civil Engineers, 2021.

[2] Source: Pisani-Ferry, Jean and Mahfouz, Selma. “The economic implications of climate action.” Republique Francaise. November 2023. There is no assurance that any estimate, forecast or projection will be realized.

[3] Secular Stagnation theory suggests that an economy can experience persistent low GDP growth, low interest rates, and high long-term unemployment due to a deficiency in aggregate demand.


On My Mind The twin roots of rising rates

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Author: Kate Lin, CAIA

Last week, we tested a strategy with two [Chinese equity indices](https://sg.morningstar.com/sg/news/211963/does-the-rhyming-%e2%80%9csell-in-may-go-away%e2%80%9d-work.aspx), and talked about how it timing the market makes you lose out on gains over the long-term. The modeling of index returns concluded that botching a market-timing decision does sacrifice a period of (strong) returns. It proved our point – time in the market is better than timing the market.

Tom Lauricella, Editorial Direct for Professional Audience at Morningstar, explains that [ineffective market-timing](https://www.morningstar.com/articles/972119/3-charts-that-show-why-investors-should-stay-the-course-throughout-market-turmoil) efforts can result in a significant opportunity cost and show the effects of missing the one best month on an annual return. “Although successful market-timing may improve portfolio performance, it is very difficult to time the market consistently,” says Lauricella, adding that the long-term gains from US stocks have been demonstrated to offset short-term losses.

Even worse, poor market timing means you give up the chance to gain more from the compounding of reinvested gains, therefore the net effect in an investment strategy is negative when compared to a portfolio that stays the course.

**What is Compounding?**

In a short answer, staying the course is the key to allow the compounding to work out. But what exactly drives compounding. Let’s start with what’s known as the ‘compound interest’ formula:

**End value = Initial value of capital*(1+Rate of change)Time**

1.  Initial Capital determines how much in absolute terms you can gain at a certain rate for a period of time.
2.  Rate of Change or the rate of investment return defines at what pace the initial and reinvested capital is to compound.
3.  Time Horizon defines for how many time periods your assets compound itself.

Put simply, compounding can be explained as the money (or returns) your portfolio earns each year, and then both your initial capital and your returns of previous years earn returns, leading to a point where you have a much larger capital pool. That means, the larger each of the equation’s components (on the right) is, the bigger your total capital would snowball into overtime.

It’s clearer in a side-by-side line graph that plots four scenarios. First, we let the base case (purple line) be a portfolio with a starting capital of $10,000. The portfolio invests in assets at the end of Year 0 that could generate an average of 10% each year and remains the same for the next 35 years.

For each of the remaining three lines, only one variable is adjusted in illustrating the outcome upon a shortened time horizon, a lower rate of return and a smaller capital to start in the equation.

![Elements in compounding.jfif](/uploads/Elements_in_compounding_c94ad1f49c.jfif)


With all else equal, beginning with capital in half means the portfolio will grow at the same rate but arriving at the exact 50% in the end value of the base case.

By contrast, when axing the investment horizon and the rate of return by half, what you afford is a return far less than just half of the base case. Shortening the investment horizon gives up the sessions that the portfolio can compound, while a smaller investment return simply flattens the curve by a large extent. Both result in merely 20% in end value as compared to the base case.

With a view to long-term performance, we go back to the base case of our data simulation and assume that in each calendar an investor adds 10% and 20%, in this case $1,000 and $2,000, to their portfolio (shown as dotted lines).

![Enlarging the compounding effect.jfif](/uploads/Enlarging_the_compounding_effect_64ba5c7108.jfif)


We find that upsizing the total portfolio value on a regular basis takes advantage of the compounding, enabling the portfolios to notch high absolute returns. This is for those who don’t have a large pot of starting investment capital, say at the early stage of their careers. Instead of sitting on cash to save up a sizable amount in some time, it is worth considering starting small to let the compound work. Expanding the capital base can come later by building up a disciplined top-up mechanism to your portfolio.

Indeed, the stock market is seen as a risky investment if you look at it for the short term. Data have shown proof that long-term returns have outsized short-term fluctuations and have triumphed over the risk of missing the one best month on an annual return by betting in and out. In practice, trying to call the trough and the peak of the market prices is distinctly tricky. The strategy involves a great deal of knowledge and luck. For individual investors who lack experience and time in technical research analysis, market timing would then be primarily driven by biases like loss aversion or herd mentality, which may cause some investors to end up buying high and selling low. Staying the course will bear fruit if you endure the time with discipline.

 

 

*©2021 Morningstar. All rights reserved. The information, data, analyses and opinions presented herein do not constitute investment advice; are provided as of the date written, solely for informational purposes; and subject to change at any time without notice. This content is not an offer to buy or sell any particular security and is not warranted to be correct, complete or accurate. Past performance is not a guarantee of future results. The Morningstar name and logo are registered marks of Morningstar, Inc. This article includes proprietary materials of Morningstar; reproduction, transcription or other use, by any means, in whole or in part, without prior, written consent of Morningstar is prohibited. This article is intended for general circulation, and does not take into account the specific investment objectives, financial situation or particular needs of any particular person. Investors should consult a financial adviser regarding the suitability of any investment product, taking into account their specific investment objectives, financial situation or particular needs, before making any investment decisions. Morningstar Investment Management Asia Limited is licensed and regulated by the Hong Kong Securities and Futures Commission to provide investment research and investment advisory services to professional investors only. Morningstar Investment Adviser Singapore Pte. Limited is licensed by the Monetary Authority of Singapore to provide financial advisory services in Singapore. Either Morningstar Investment Management Asia Limited or Morningstar Investment Adviser Singapore Pte. Limited will be the entity responsible for the creation and distribution of the research services described in this article.*

How Your Money Works for You

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Author: Carole Hodorowicz

It can be a challenge for investors just getting started to learn how to tackle debt, start saving, or find the best ways to pay off loans. Compounded by the coronavirus pandemic, addressing your financial situation can seem even more daunting when trying to learn the basics. 

We surveyed some of Morningstar's[ Generation Z and millennial employees ](https://www.morningstar.ca/ca/news/202904/generation-z-has-the-right-attitude.aspx)to hear their thoughts around money. Here are five lessons they learnt: 


**1. Paying Down Student Loans**

At the start of the pandemic, [the Government announced](lhttps://www.canada.ca/en/services/benefits/education/student-aid/notice-covid-19.html) measures to help students, including payment freezes.

There are pros and cons to continuing payments, and many good ways to make use of the money, like creating or building an emergency fund. If you contributed to your loans anyway, you reduced your principal. Paying down student loans is typically approached in one of two ways: [the snowball method and the avalanche method](https://www.morningstar.ca/ca/news/206124/how-to-paydown-debt.aspx). The snowball method prioritizes paying off the smallest loans first, while the avalanche method focuses on paying off the loan, no matter its size, with the highest interest rate first.

Here's how one employee took advantage of the grace period:

"As the pandemic happened and the government decided to set student loan interest rates to zero, I prioritized paying off as much as I could each month. I felt that I should try to pay the principal down since I will not have any interest eating away at my overall bill."


**2. Tackling Credit Card Debt**

With fewer ways to spend, some may turn their attention to paying down debt.

When approaching any kind of debt, you may be asking yourself the same question: Where do I even begin? Morningstar's director of personal finance Christine Benz recommends taking these steps first:

1) Buy yourself some time. Does your bank offer any options to extend a grace period or reduce your interest rate?

2) Make a list. How much do you owe, who do you owe, how much time you have, and what are the interest rates?

3) Pick a strategy. Do you want to go with the snowball method or the avalanche method

Here's a takeaway from one employee who focused on credit card debt:

"It's given me a new respect for that feeling of 'getting ahead' on payments. It's given me a chance to think more about my long-term savings goals--when I was so caught up in day-to-day spending, I didn't think as much about what I should be saving that money for instead." 


**3. Creating and Maintaining an [Emergency Fund](https://www.morningstar.ca/ca/news/206579/morningstar-money-challenge-day-7.aspx)**

The pandemic helped highlight the need to be financially prepared for the unexpected.

Our investment specialists recommend these tips to get a solid footing in the event of any unforeseen circumstances:

1) Tally up your monthly living expenses, from rent to groceries. Leave out the nonessential purchases.

2) Multiply these costs by three months. This is the minimum amount you should try to squirrel away.

3) See how much you currently have and set a savings goal.

During this time, many readjusted their focus to their emergency funds. Here's what one employee realized during this time:

"I believe that having a more holistic approach to budgeting is essential. Pre-pandemic, I was only focused on one aspect of my financial plan: paying off debt. Since the pandemic, I realized the importance of building up my emergency fund and having a backup plan in case of an unexpected occurrence." 


**4. Increasing Retirement Contributions**

The pandemic pushed some of our colleagues to look long term and consider how to stay on track for their retirement. Another effective use of the extra time and funds on your side is to focus on investing in your retirement plan. The earlier you invest, the more growth potential your retirement account will have.

Here's how one employee's priorities changed:

"After graduating from college during the pandemic, my biggest concern was finding a way to earn money. Now with a job, I am leaning into more savings, including a six-month emergency fund instead of a three-month and reaching my RRSP contribution limit."

It's never too early to plan for retirement.


**5. Cutting Back**

With office closures and stay-at-home mandates, several employees who responded to our survey said they are rethinking their spending habits during the pandemic. 

Here is how an employee embraced Morningstar's mission to think and invest with the long term in mind:

"I have been spending a lot less in areas that I would have normally spent on and putting more in savings. One thing I hope to do is work on finding a better balance between savings and investing and spending while not feeling like it restricts my lifestyle." 


5 Financial Lessons for New Investors

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Author: Valerio Baselli

Looking at the market today, it's easy to forget where we were at around 15 months ago. Many of the market declines of the past decade or so, including the stock market crash of 2008, are fast becoming faded memories for most of us. But it is the investors who endured these difficult times came out in perhaps the best shape, and as is often the case, those who had the nerve to stay invested were richly rewarded.

And yet, the decision about whether to change your investment strategy or sell a fund is usually not clear-cut, even in hindsight. After the dust has settled on a decision and the investment has performed well or poorly, the “right” answer is wholly dependent on the individual. Selling criteria are not a one-size-fits-all list that fit every investor, but there are some situations when selling is particularly ill-advised. Christine Benz, director of personal finance at Morningstar, picks these three key examples.

**Poor Short-Term Performance**
 
It’s almost never a good idea to sell a fund based on weak performance alone, especially over the short-term. You might have been tempted to sell in last year's market sell-off for example, but we now know the Covid crash was the shortest in history. Instead, if a fund is lagging its peers or an index, your first move should be to investigate why that is. It could be that the manager is simply sticking with an investment strategy that happens to be out of favour, as has been the case with many value-leaning funds in recent years. But weak performance may also be a sign that something more serious is afoot - Morningstar's own research has found that many active funds fail to beat the market over the long-term.

Researching an investment’s fundamentals can be time-consuming, which is why you don't want to get too caught up in investigating short-term bouts of underperformance. Most funds, especially those that are using truly active strategies, will trail their peers at times, often for very good reasons and sometimes for a few years or more (that could be the case with some perfectly solid, defensively positioned funds during a market rally, for example).

Instead, save your energy for checking up on funds when they've underperformed over longer stretches of time or in a period when you would have expected them to perform well. If, for example, you selected a fund because of its low-risk tendencies, but it lost far more than its peers in 2020, that's a legitimate reason to ask whether something about its strategy changed or its risk controls weren’t what you thought they were. And even if the fund isn’t bad, it may not be a good fit in your portfolio.

**Inconsistent Performance**

On a similar vein, investors often get themselves worked up when a fund’s relative returns are inconsistent on a year-to-year basis. Sure, it can be comforting to see a fund land in its category's top half like clockwork—and a small handful of funds has actually managed to generate return rankings that have been remarkably consistent from year to year.

But holding all of your funds to that standard would cause you to kick out some fine offerings that, while not consistent performers on a calendar-year basis, are consistent where it counts: they employ their strategies with discipline and don't waver, even if the market isn't rewarding them in the near term.

It's also important to remember that a calendar year is a fairly short and arbitrary time period, and a fund that has looked erratic over January-December time periods may appear perfectly consistent when measured over a different 12-month time frame—say, from April to March of each year. Investors shouldn't get too hung up on year-to-year performance consistency when deciding what to hold in their portfolios. Looking at annualised returns can be a better way to judge long-term performance, as these smooth out good and bad periods to indicate what average return an investor has received each year. 

**Macroeconomic News**

Macroeconomic news - whether it's the direction of interest rates, rising inflation or GDP growth in China and India - often appears right alongside news about the market's trajectory. And it's true that what's in the headlines has the potential to move the markets up or down on a daily basis, or even over longer time frames. The trouble is that by the time a certain news item makes its way into the headlines, other market participants have already digested it and priced it in.

If you decide to sell your fund based on that news, you're likely to be too late. Instead, a better tack for investors, at least as it relates to their portfolios, is to keep their heads down and focus on factors that they can control: their savings and spending rates, the quality of their investment holdings, and the total costs they pay for those investments. There is much virtue in tuning out the noise when it comes to managing your portfolio.





*©2021 Morningstar. All rights reserved. The information, data, analyses and opinions presented herein do not constitute investment advice; are provided as of the date written, solely for informational purposes; and subject to change at any time without notice. This content is not an offer to buy or sell any particular security and is not warranted to be correct, complete or accurate. Past performance is not a guarantee of future results. The Morningstar name and logo are registered marks of Morningstar, Inc. This article includes proprietary materials of Morningstar; reproduction, transcription or other use, by any means, in whole or in part, without prior, written consent of Morningstar is prohibited. This article is intended for general circulation, and does not take into account the specific investment objectives, financial situation or particular needs of any particular person. Investors should consult a financial adviser regarding the suitability of any investment product, taking into account their specific investment objectives, financial situation or particular needs, before making any investment decisions. Morningstar Investment Management Asia Limited is licensed and regulated by the Hong Kong Securities and Futures Commission to provide investment research and investment advisory services to professional investors only. Morningstar Investment Adviser Singapore Pte. Limited is licensed by the Monetary Authority of Singapore to provide financial advisory services in Singapore. Either Morningstar Investment Management Asia Limited or Morningstar Investment Adviser Singapore Pte. Limited will be the entity responsible for the creation and distribution of the research services described in this article.*

3 Bad Reasons to Sell a Fund

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###### **Important Information:**

- ###### The value of investments and the income from them can go down as well as up and investors may not get back the amount invested.
- ###### For funds that invest in overseas markets and the value of investments can be affected by changes in currency exchange rates.
- ###### For funds that invest in emerging markets which can be more volatile than other more developed markets.
- ###### For funds that use financial derivative instruments for investment purposes, which may expose the fund to a higher degree of risk and can cause investments to experience larger than average price fluctuations.
- ###### For funds that may make increased and more complicated use of derivatives and this may result in leverage. In such situations performance may rise or fall more than it would have done otherwise. The fund may be exposed to the risk of financial loss if a counterparty used for derivative instruments subsequently defaults.
- ###### Reference to specific securities should not be construed as a recommendation to buy or sell these securities and is included for the purposes of illustration only.
- ###### Currency hedging may be used to substantially reduce the risk of losses from unfavourable exchange rate movements on holdings in currencies that differ from the dealing currency. Hedging also has the effect of limiting the potential for currency gains to be made.
- ###### Investors should note that the views expressed may no longer be current and may have already been acted upon.
- ###### Past performance is not a reliable indicator of future returns.

![writer1.png](/uploads/writer1_e9c1fc40d0.png) 
 **Rahul Srivatsa**, Portfolio Manager
 ![writer2.png](/uploads/writer2_26ed318b2f.png)
**Stefan Rusev**, Senior SAA Strategist
 
![writer3.png](/uploads/writer3_9274676874.png)
**Isabella Labak**, Director, Client Solutions

The years since the Covid pandemic have marked a significant departure in macroeconomic conditions from the preceding decade. In the period after the financial crisis, easy monetary policy helped to flatten macroeconomic volatility. However, today investors must grapple with greater uncertainty about inflation and central bank rates, as well as widening fiscal deficits, escalating protectionism, and more positive equity-bond correlations. We believe this marks the beginning of a new macroeconomic regime, and that building portfolios that are resilient to these new challenges will require a different approach to the one that was successful in the past. In particular, investors may need to look beyond traditional asset classes to achieve the diversification that they are used to.

Our research shows that diversifying liquid alternatives could have an important role to play in increasing the robustness of portfolios in this new environment. Liquid alternatives are assets and strategies that are both liquid and offer different risk and return characteristics to those of equities and bonds. The universe is highly diverse, ranging from gold to equity long-short strategies to put options. We think about liquid alternatives in three distinct groups - ‘Carry’, ‘Diversifying’ and ‘Hedging’. Carry strategies tend to perform well in benign or ‘risk on’ markets, diversifying strategies have little or no correlation to broader markets, while hedging strategies are those that tend to perform well in ‘risk off’ markets.
 


![figure1.jpg](/uploads/figure1_432135398e.jpg)

In this paper, we will focus specifically on diversifying liquid alternatives and outline the strong medium-term case for allocating to this strategy group within a balanced portfolio. The first section sets out why we believe that the medium-term macroeconomic outlook of elevated inflation and volatility, higher equity-bond correlations, and higher bond valuations, means that investors might need to look beyond bonds alone for diversification when building robust portfolios. The second section details our research into the beneficial impact diversifying liquid alternatives can have on portfolio resilience and mitigating tail risks. The final section provides a summary of our approach to portfolio construction with this diverse asset class.
 

## Macro outlook highlights the benefits of alternative forms of diversification

The global economy has faced a number of shocks since the onset of the Covid pandemic, from lockdowns to extraordinary government spending to runaway inflation in developed markets. We have entered a new macroeconomic regime of greater protectionism, more volatile inflation, and wider fiscal deficits. We believe that there are two key characteristics of this environment that could reduce the diversification benefits of bonds compared to the pre-pandemic era - higher and more volatile inflation and higher bond valuations.

### Higher inflation volatility

The period between the financial crisis and the pandemic was marked by low inflation and broadly negative equity-bond correlations, which meant that investors could achieve relatively robust diversification with just equities and bonds.

However, as Figure 2 shows over the past four years, macroeconomic volatility, particularly inflation and inflation volatility, has risen substantially as a result of post-pandemic central bank monetary stimulus, supply chain disruptions, and de-globalisation. Given that this has taken place outside of a recession, we believe it signals a return to a higher volatility regime over the medium-term.
 

![figure2.jpg](/uploads/figure2_5da84ea81b.jpg)

While the explicit inflation targets of many developed market central banks will help combat this, we believe that structural trends including decarbonisation, de-globalisation, and widening fiscal deficits will cause inflation to be higher and more volatile in the coming years than in the post-financial crisis era. For further information on our inflation forecast, please refer to [Insight into Fidelity’s capital market assumptions](https://www.fidelity.lu/static/master/media/pdf/download-material/capital-market-assumptions.pdf).

As Figure 3 shows, higher inflation implies equity-bond correlations will also be higher in the coming years. Higher correlations between the major asset classes means investors may need to consider other sources of diversification to achieve the same level of portfolio resilience as in the past.
 

![figure3.jpg](/uploads/figure3_a898667a06.jpg)

The new reality of higher inflation and the subsequent impact to equity-bond correlations was apparent in 2022, when surging inflation in developed markets caused correlations to spike. The failure of bonds to offset equity losses that year caught many investors off guard. A sustained period of positive correlations would be a significant change from the 20-year period between 2000-2020 of broadly negative correlations that many of today’s investment strategies are based on. As Figure 4 shows, equity-bond correlations tend to fluctuate, and persistent negative correlations are in fact rare rather than the norm.
 

![figure4.jpg](/uploads/figure4_c5144e5286.jpg)

A further consequence of higher and more volatile inflation is higher bond volatility. The relative calm of the pre-pandemic era made bonds a stable investment. However the more uncertain future means that investors will not be able to depend on bonds in the same way they did in the past for diversification.

We believe this further increases the attractiveness of other assets that can provide additional diversification and return benefits to portfolios alongside bonds. This is especially true for certain diversifying liquid alternatives, such as hedge funds and absolute return strategies, which generally benefit from more trading opportunities when volatility and dispersion are elevated, allowing them to achieve higher levels of return at a time when traditional asset classes may struggle.

### Higher credit valuations

Current credit valuations indicate that returns are likely to be lower over the coming years. Unlike equities, credit valuations, in the form of credit spreads, are a relatively reliable indicator of medium-term returns. Spreads today are amongst the lowest since records began, resulting in a pronounced negative return asymmetry, particularly for investment grade bonds. Replacing some fixed income exposure with alternative forms of diversification could help offset this risk.
 

![figure5.jpg](/uploads/figure5_0c1800c0ae.jpg)
 
## Diversifying liquid alternatives can enhance long-term portfolio outcomes

Our research suggests that allocating to diversifying liquid alternatives can enhance long-term investment outcomes. Investors must decide whether this fits with their own objectives and preferences, but for those willing and able to access this strategy group, their use can shift the efficient frontier upwards and to the left - offering higher returns for a given level of risk or lower risk for a given return.

As Figure 6 illustrates, this can be particularly important in regimes with higher bond volatility and high equity-bond correlations, such as we expect in the coming years. These conditions increase portfolio risk, which materially lowers the efficient frontier. The sample analysis in Figure 6 uses the realised covariances of the last five years, a snapshot of a period with much higher equity-bond correlations than the preceding 20 years, demonstrating that diversifying liquid alternatives can help keep the frontier closer to equilibrium expectations - helping provide better risk-adjusted investment outcomes.
 

![figure6.jpg](/uploads/figure6_e6020d5e8d.jpg)

The diversification benefits of liquid alternatives come from their low correlations with traditional asset classes. In general, we look for an asset class to fall within a correlation range +/-0.25 to be considered as having a low or uncorrelated risk and return profile.
 

![figure7.jpg](/uploads/figure7_a25493e97d.jpg)

In addition, the slightly negative correlation between diversifying liquid alternatives and US Treasuries is advantageous in portfolio design because investors often seek out diversifying exposures for returns and protection when risks increase in traditionally defensive market areas.

While informative, these numbers can mask prolonged periods of instability. Regime analysis can provide a deeper understanding of how asset classes might behave under different conditions and over time. Figure 8 reveals the average expected performance of diversifying liquid alternatives, US Treasuries, and developed market equities across six distinct growth and inflation regimes.
 

![figure8.jpg](/uploads/figure8_51d5151cbd.jpg)

Generally speaking, diversifying liquid alternatives exhibit broadly stable performance across different regimes, including in high inflation regimes when equities and bonds tend to perform poorly. This is noteworthy given our expectation of higher macroeconomic and inflation volatility. A bearish environment, where growth is falling and inflation normal, is the regime that the asset group performs the worst in, but even here the negative performance is reasonably contained and can be mitigated by appropriately sized allocations and selection of the optimal strategies.

Drawdowns are also an important part of diversification. It’s crucial to understand whether drawdowns in diversifying liquid alternatives coincide with drawdowns in equities and bonds - in other words, are the diversification benefits there when they are needed most? Our analysis shows that the strategy group does indeed tend to offer support when traditional assets come under pressure.
 

![figure9.jpg](/uploads/figure9_f095dde215.jpg)

![figure9-2.jpg](/uploads/figure9_2_09bd4d7a82.jpg)
 

## Constructing portfolios with liquid alternatives

The idiosyncratic nature of the liquid alternatives universe makes it crucial to understand the risk and return characteristics of each strategy. Our approach involves categorising the liquid alternatives universe in such a way to allow us to construct portfolios that align with our clients' diverse objectives, ensuring precise and consistent exposure tailored to various risk and return requirements.
 

![figure10.jpg](/uploads/figure10_b672a9a53c.jpg)

For example, investors seeking diversification and growth could consider allocating to ‘carry’ and ‘diversifying’ strategies, whereas those looking for defensive diversifying exposure could consider a ‘hedging’ portfolio alongside ‘diversifying’ strategies. When creating a balanced allocation to diversifying liquid alternatives by blending together complementary strategies, the resulting volatility profile means that the allocation is typically funded by reducing the proportion of bonds in a portfolio. As an asset allocation’s expected volatility increases, the exposure can also be funded from higher-risk assets, however further adjustments to the asset allocation will be needed to keep the overall risk profile constant.

Researching individual strategies is an important part of building portfolios with liquid alternatives. Splitting the universe into three broad strategy groups is helpful, but there are still significant differences between strategies in each category due to the large range of sub-style and implementation choices available. Selecting the appropriate strategies helps maximise returns and minimise risks, while the inclusions of inappropriate and under researched strategies could lead to missed opportunities or unexpected risks. As such, a robust strategy research and portfolio construction framework is needed. Our approach emphasises accountability and specialism alongside ongoing monitoring and review to ensure any selection delivers outcomes consistent with objectives.

Our portfolio construction process for the diversifying liquid alternatives building block avoids statistical optimisation and is designed with a focus on first principles of diversification and tail risk assessment to capture the idiosyncratic nature of the strategies being invested in. More specifically, when constructing an allocation, we use an equal volatility weighting as our neutral starting point. From there we amend exposures to individual strategies in order to maximise risk-adjusted return while factoring in convictions, tail risk, and diversification properties to mitigate drawdowns. More specifically, we assess the distribution of returns, maximum drawdowns, and qualitatively assess the correlation of drawdowns when further amending allocations.
 

## Diversifying liquid alternatives can enhance portfolio outcomes

We believe that the current economic landscape, characterised by wider fiscal deficits, increasing protectionism, and unstable inflation, marks the start of a new macroeconomic regime of higher volatility and higher equity-bond correlations. Investors who adapt to these new conditions rather than stick to what worked in the past are likely to be rewarded with portfolios that are more resilient in the future.

We believe that diversifying liquid alternatives have an important role to play in building robust portfolios in the coming years, offering diversification benefits and having shown resilience in high inflation regimes. Our approach to portfolio construction allows us to help clients get the most out of this strategy group by creating tailored allocations that align with their specific needs.

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###### This material is provided for information purposes only and is intended only for the person or entity to which it is sent. It must not be reproduced or circulated to any other party without prior permission of Fidelity.
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###### This communication is not directed at, and must not be acted on by persons inside the United States. All persons and entities accessing the information do so on their own initiative and are responsible for compliance with applicable local laws and regulations and should consult their professional advisers. This material may contain materials from third-parties which are supplied by companies that are not affiliated with any Fidelity entity (Third-Party Content). Fidelity has not been involved in the preparation, adoption or editing of such third-party materials and does not explicitly or implicitly endorse or approve such content. Fidelity International is not responsible for any errors or omissions relating to specific information provided by third parties.
###### Fidelity International refers to the group of companies which form the global investment management organization that provides products and services in designated jurisdictions outside of North America. Fidelity, Fidelity International, the Fidelity International logo and F symbol are trademarks of FIL Limited. Fidelity only offers information on products and services and does not provide investment advice based on individual circumstances, other than when specifically stipulated by an appropriately authorised firm, in a formal communication with the client.
###### Europe: Issued by FIL Pensions Management (authorised and regulated by the Financial Conduct Authority in UK), FIL (Luxembourg) S.A. (authorised and supervised by the CSSF, Commission de Surveillance du Secteur Financier), FIL Gestion (authorised and supervised by the AMF (Autorité des Marchés Financiers) N°GP03-004, 21 Avenue Kléber, 75016 Paris) and FIL Investment Switzerland AG.
###### In Hong Kong, this material is issued by FIL Investment Management (Hong Kong) Limited and it has not been reviewed by the Securities and Future Commission.
###### FIL Investment Management (Singapore) Limited (Co. Reg. No: 199006300E) is the legal representative of Fidelity International in Singapore. This document / advertisement has not been reviewed by the Monetary Authority of Singapore.
###### In Taiwan, Independently operated by Fidelity Securities Investment Trust Co. (Taiwan) Limited 11F, No.68, Zhongxiao East Road, Section 5, Taipei 110, Taiwan, R.O.C. Customer Service Number: 0800-00-9911.
###### In Korea, this material is issued by FIL Asset Management (Korea) Limited. This material has not been reviewed by the Financial Supervisory Service, and is intended for the general information of institutional and professional investors only to which it is sent.
###### In China, Fidelity China refers to FIL Fund Management (China) Company Limited. Investment involves risks. Business separation mechanism is conducted between Fidelity China and the shareholders. The shareholders do not directly participate in investment and operation of fund property. Past performance is not a reliable indicator of future results, nor the guarantee for the performance of the portfolio managed by Fidelity China.

Enhancing portfolio resilience with diversifying liquid alternatives

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## A new attribution approach to enhance ESG transparency

#### Financial institutions, traditionally focused on maximizing returns, now acknowledge that their capital allocation decisions have real-world implications, from carbon emissions to labor practices and board diversity. This shift has made integrating ESG factors into investment strategies a crucial aspect of portfolio management.

To effectively navigate this evolving landscape, investors rely on performance attribution to assess whether their decisions align with initial expectations. This process helps determine whether investment choices met financial and ESG goals or if unforeseen variables influenced the outcome. For example, if a portfolio aims to outperform a benchmark in terms of carbon emissions or achieve net zero by a specific year, performance attribution helps investors analyze both financial returns and environmental impact, creating a continuous feedback loop to refine decision-making.

### Building an ESG attribution framework

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Regulatory frameworks, such as the EU’s Sustainable Finance Disclosure Regulation, further reinforce the importance of ESG transparency by requiring funds that incorporate ESG considerations to disclose their practices and results. As a response to this growing need, Ortec Finance and MN - a leading Dutch fiduciary asset manager - have developed an attribution model that enables investors to compare their portfolio’s performance against benchmarks for both financial and non-financial metrics, such as carbon emissions and ESG factor scores.

The model not only attributes ESG metrics to specific investment decisions but also captures both intended and unintended consequences. Initial testing with real data from two client portfolios revealed that exclusion policies significantly reduced financed emissions, while weight caps on certain exposures designed to limit financial volatility had unintended negative impacts on carbon footprints.

An important next step for an ESG attribution calculation is to analyse the ESG performance of the portfolio over time and attribute the performance of the portfolio compared to the benchmark to different investment decisions.

In a recently released whitepaper, co-authored by Ortec Finance and MN, we explain this new ESG attribution framework in more detail.

[Download](https://www.ortecfinance.com/en/insights/research/esg-attribution-the-development-of-an-attribution-model) the whitepaper or contact us today if you want to speak to one of our experts.

Contact
### Sam Radford
Medior Business Specialist Investment Performance

Email: [Sam.Radford@ortec-finance.com](mailto:Sam.Radford@ortec-finance.com)

ESG Attribution – The development of an attribution model

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