Think market valuations are maxed out? Jim Caron, CEO of Portfolio Solutions Group at Morgan Stanley Investment Management, shares smart asset selection strategies to keep your portfolio thriving in 2025.
- Passive bond strategies might struggle, but active management can unlock opportunities by focusing on smart asset selection.
- With high valuations, earnings growth and targeted investment choices are your best bet for higher returns.
- Diversifying into private markets and alternatives can provide stability and better valuations for your portfolio.
Investors rarely agree on any one point; after all, there is a buyer and a seller at every price. But as we enter 2025 most investors do agree on one thing: Market valuations seem to be full and not many think assets are cheap. This is true across both fixed income and equities, the most widely-traded asset classes.
The question we then ask about 2025 is: How do you invest in a fully-valued market? The simple answer is to optimize asset and investment selection in portfolios, because their return attributions may make a bigger difference than has been the case over the last several years. Said differently, we must prioritize alpha over beta. Let’s get into it!
Bonds: The Biggest Challenge, Yes, But, Perhaps the Best Opportunity
Bonds present the biggest challenge because their expected return and valuations are tied to the well-telegraphed path of policy rates. The majority of bond returns stem from duration, i.e. their sensitivity to interest rate movements. In fact, over 80% of bond returns in the Bloomberg Aggregate Bond Index could be historically attributed to duration over the past 40 years. Much of the remaining portion of returns comes from the coupon, with a bit left over from convexity.
Given that the Fed is expected to cut interest rates, much of the return in bonds has already been priced in. In addition, credit spreads are trading near historically tight levels so there is little excess return for passive investors to extract from fixed income.
But here’s where the opportunity comes in. While it may be true that there are great challenges for passive bond investors that rely mainly on beta to drive returns, the opposite is true for those who invest in actively-managed fixed income strategies. These active investors rely less on the interest rate cycle, or beta, to drive returns. Instead, they rely more on asset selection and investment selection.
Since the majority of investors in fixed income tend to employ passive strategies, we believe those who engage with active management strategies have a great opportunity to add alpha to their return attributions and differentiate themselves.
Equities More About Factors and Alpha Than Beta
Consistent with our theme for 2025, valuations are the crux of the equity debate. This is often measured in price-to-earnings (P/E) multiples, which are currently high and seem fully valued.
What this means is that it may be difficult for equity return attributions to come mainly from an increase in broad-based multiples, or beta, in equity markets. Of course, it’s possible for multiples to expand but it may take some form of “irrational exuberance” for this to occur.
Many believe that 22x earnings is a high hurdle to sustainably exceed under current conditions - and we agree. Valuations across equity markets typically hinge on three variables: the level of interest rates, the cost of credit and default risks and the composition of the index itself, i.e. if the index is more heavily weighted toward higher or lower P/E stocks.
Since the lower interest rate impulse has passed, and the yield curve is steepening, multiple-expansion-based gains in equities may lose a tailwind. Rising equity prices may become more reliant on earnings from the broader market.
As a result, we expect alpha, not beta, to become a larger source of return attribution. Perhaps this is fed by the “old” economy value sectors finding gains from the “new” economy technology sectors, as Capex, AI and electrification increases productivity in broader-based cyclical sectors of the economy.
In Display 1 we illustrate that there is a large gap between the broader market, as represented by the equal-weighted S&P 500 and the market-cap-weighted version.
By positioning portfolios, and selecting assets and active investment styles, we believe closing this gap is the key to performance as we move into 2025. The lines may be blurred between growth, value, small, mid and large cap as a result.
Conclusion
We believe it’s time to change the way we think about market performance, from being confined to sectors and narrow breadth, to factors and a widening breadth. We prefer to focus on free-cash-flow yield, earnings growth, pricing power, profitability and strong balance sheets
Selecting investments and managers that can exploit this value intra-sector may rise in importance compared with simply just picking a sector.
For bonds, we think active management is critical to driving alpha over the beta provided by the interest rate cycle. We also believe that alternatives and private market investments will play a growing role in a balanced and well-diversified portfolio, especially since their valuations are more representative of early-cycle dynamics than public markets that seem later cycle.
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Any opinions, news, research, reports, analyses, prices, or other information contained within this research is provided by an external contributor as general market commentary and does not constitute investment advice for the purposes of the Financial Advisory and Intermediary Services Act, 2002. First World Trader (Pty) Ltd t/a EasyEquities (“EasyEquities”) does not warrant the correctness, accuracy, timeliness, reliability or completeness of any information (i) contained within this research and (ii) received from third party data providers. You must rely solely upon your own judgment in all aspects of your investment and/or trading decisions and all investments and/or trades are made at your own risk. EasyEquities (including any of their employees) will not accept any liability for any direct or indirect loss or damage, including without limitation, any loss of profit, which may arise directly or indirectly from use of or reliance on the market commentary. The content contained within is subject to change at any time without notice.
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