Four strategies for a world
of uncertainty
Numerous risks to global growth continue to challenge
investors around the world, even as equity and bond
markets evolve under new regulations, macroeconomic
pressures, and complex geopolitical realities. In this
paper, we make the case that the many uncertainties of
today need not reduce investors to inaction. We believe
there are ways to maneuver in today’s markets that can
help investors move toward a better future.
Putnam suggests a variety of approaches that financial
advisors and their clients can take to actively respond
to today’s markets, better manage risk, and actually
seize opportunities that current market turmoil may be
masking. We divide these approaches into four basic
challenges and actions to consider.
Each category speaks directly to specific market
segments that have been transformed by interventionist
central bank policy and macroeconomic uncertainties
in the years since the financial crisis. Taken together,
these categories cover a broad spectrum of asset
classes and strategies, ranging from short-term fixed
income and multi-sector to new allocation and absolute
return approaches. As detailed elsewhere, Putnam
promotes specific fund solutions for advisors and
investors to consider in the context of their portfolios.
Driven by research insights, our
strategies address key challenges
facing investors today.
NAVIGATE INTEREST RATES
Look beyond common benchmarks
and traditional core bond strategies.
EXPAND SHORT-TERM CHOICES
Consider new possibilities as a response to
changing money market regulations.
DIVERSIFY TO HELP REDUCE RISK
Apply all modern tools, including asset and
risk allocation and absolute return strategies.
PURSUE GREATER RETURNS
Embrace active selection strategies and focus on
the factors that can sustain profit growth.
Q1 2016 | Four strategies for a world of uncertainty
Invest for income by
thinking outside of indexes
• Common bond benchmarks could see volatility like 2013’s “taper tantrum” again.
• Investing for income will be challenged as the Fed moves rates higher.
• It is possible to navigate rates by maneuvering outside common indexes.
Bonds attract investors as a source of income and a refuge from the volatility of stocks.
But these qualities should not obscure the fact that as bond yields have fallen, interest-rate
risk has increased in the Barclays U.S. Aggregate Bond Index, a major benchmark.
As a result, typical portfolios pursuing income with benchmark-aligned strategies may be less
safe than many people think. In 2013, when Fed policy makers merely revealed a discussion
of “tapering” the central bank’s quantitative easing program, the Barclays U.S. Aggregate Bond
Index delivered its first negative annual result in more than a decade, returning -2.02%.
And, today, interest-rate risk in the index is just as high — if not higher — than in 2013.
How to outmaneuver rate risk
Investors have an alternative to invest outside of indexes and consider security types that are
not overly subject to the risk of rising rates. When we consider such non-Aggregate sectors
of the bond market, the “spread” — or difference in yield between a given sector and U.S.
Treasuries of equal maturity — highlights several areas of potential opportunity. Spreads today
in some sectors are higher than their long-term averages leading up to the financial crisis.
Of course, it takes resources to conduct careful research in out-of-benchmark sectors, but it is
one way to position a portfolio to be prepared for rising rates.
Lots of duration for little yield in the Barclays Agg
Billions of dollars are invested in strategies aligned with a benchmark that carries substantial
interest-rate risk.
Historical yield
Duration risk
10
8
8
6
6
4
4
2
2
0
1989
1994
1999
2004
2009
0
2015
Sources: Barclays, Putnam, as of 12/31/15. This chart uses yield to worst as the representation of yield. Yield to
worst is the lowest yield that an investor can expect when investing in a callable bond. Duration measures the
sensitivity of bond prices to interest-rate changes. A negative duration indicates that a security or fund may be
poised to increase in value when interest rates increase. Barclays U.S. Aggregate Bond Index is an unmanaged
index of U.S. investment-grade fixed-income securities. You cannot invest directly in an index.
2
Duration (years)
10
Yield (%)
NAVIGATE
INTEREST
RATES
Putnam Investments | putnam.com
EXPAND
SHORT-TERM
CHOICES
With rules changing,
widen the playing field
• New regulations change investment opportunities at the short end of the yield curve.
• More, not less, volatility may be the result, generating potential mispricing.
• An active strategy can pursue both greater income and broader diversification in this terrain.
If the investment environment since the 2008 financial crisis has had one constant, it is
expanded — and, often, poorly understood — regulatory oversight. While intended to maintain
stability, untested policies can often have unintended consequences and far-reaching effects.
New regulation of money market funds provides a good example. It focuses on three key points:
shorter maturities for securities owned, greater liquidity for the overall portfolios, and an
increase in the average credit quality of holdings. On each measure, greater safety would seem
the likely result. However, it is also reasonable to assume that the new regulatory framework
could cause behavioral changes by investors that increase volatility and price dislocations.
Explore new short-term options
As we see it, the changing regulations imposed on the money markets have opened a new
space for expanding short-term investment options. Effectively, debt securities that until
recently were deemed to be money-market eligible but are now off limits have been given a
new lease on life: By being excluded from the money market category, they offer a slight yield
advantage relative to their more constrained money-market-eligible counterparts. In this way,
short-term investment vehicles that can exploit the space between money markets and
ultra-short bond funds may simultaneously offer a robust capital preservation profile as well
as real higher-yield potential.
Exploiting new short-term investment territory
Debt securities that were once money market eligible provide new opportunities for strategies
that can invest just outside the money market universe.
Lower risk,
lower yield potential
Higher risk,
higher yield potential
TAXABLE
MONEY MARKET FUNDS
ROOM FOR SOMETHING
IN BETWEEN
ULTRA-SHORT
BOND FUNDS
Newly revised money
market rules have
limited the field of
investable securities.
Now outside the realm
of money markets,
securities that are less
risky than “ultra-short”
bonds represent a new
opportunity.
Ultra-short bond
funds may contain
longer duration and
higher credit risk than
investors realize.
3
Q1 2016 | Four strategies for a world of uncertainty
DIVERSIFY TO
HELP REDUCE
RISK
Balance a portfolio with a plan
for the downside
• The “risk-on, risk-off” market mentality of recent years leads to poor risk management.
• Serving investors with long-term goals means planning for durable diversification.
• Modern all-weather allocation means including a broader set of asset classes and
absolute return strategies.
Volatility may be the biggest challenge to investors in this or any other year. No matter the
level of one’s experience, investors must all confront the market’s rapid transformations from
euphoria to fear and back again. Amid a barrage of market-moving headlines, investors do not
generally think about their risk management or act on measured analyses of fundamental data
relative to specific companies’ prospects. Many move with the herd.
Experienced financial managers and advisors know, however, that rapid-fire changes to an
investment plan can lead to whipsawing performance and sacrifice the benefits of proper
diversification. A well-diversified portfolio seeks to moderate short-term risk by taking
advantage of low correlations among asset classes, thereby leading to better compound
returns — one of the few “free lunches” still available to the average investor.
Seek a better balance with modern diversification for all kinds of market conditions
The classic diversification strategy of portfolio balance is a concept that Putnam has
championed for nearly 80 years. But we have also taken it to new levels.
Stepping beyond tradition is valuable because of the high degree of equity risk that is still
concentrated in a classic 60/40 balance, in which nearly 90% of the risk comes from the equity
holdings. And, as we have seen too often, in a high-volatility regime, particularly one driven by
systemic financial market stress, correlations within equities can rise dramatically.
Even seeking safety can be risky,
especially when it involves unintentionally
abandoning longer-term objectives by
focusing solely on short-term scorecards.
4
Putnam Investments | putnam.com
That is why it is important to both globalize allocations
and include a broader set of asset classes: domestic
and international fixed income across the quality
spectrum, as well as inflation-oriented securities —
including commodities, real-estate-related securities,
and Treasury Inflation-Protected Securities (TIPS).
Independent of traditional equity and fixed-income
benchmarks, an absolute-return manager has no
motivation to follow the market’s herd mentality.
Instead, the manager’s foremost concern is risk-adjusted
performance, a look-before-you-leap mentality. It works
by constructing portfolios with a variety of strategies
uncorrelated with each other, and with the goal of greater
independence from market direction. Absolute return
provides an active form of tail risk management valuable
for any portfolio charting a long-term course.
But there is still more that modern diversification can
achieve through an absolute return strategy. Taking
advantage of the broadest possible toolkit, an absolute
return approach can capture a portion of the upside
potential of any market rally while consistently seeking
to mitigate market volatility.
Absolute return funds combine many tools to manage risk
Unlike funds focused on a specific area of the market, absolute return funds can invest with greater flexibility.
ABSOLUTE
RETURN FUNDS
TRADITIONAL
BOND FUNDS
TRADITIONAL
BALANCED FUNDS
U.S. STOCK
FUNDS
INTERNATIONAL
STOCK FUNDS
Absolute flexibility
Defines positive return targets
AVAILABLE STRATEGIES
U.S. bonds
U.S. stocks
Foreign bonds
Foreign stocks
Emerging markets
Commodities
Hedging strategies
REITs
Cash
All funds involve different levels of risk, have different fees and expenses, and have different objectives that you should consider before investing.
Absolute return funds have fewer limitations on where they can invest as compared with traditional funds. They have the ability to move among
security types (i.e., stocks, bonds, cash, and alternatives), capitalization ranges, styles, durations, credit qualities, and geographic regions.
This flexibility in terms of asset allocation offers the advantage of improved portfolio diversification as compared with many traditional funds.
Absolute return funds also may have additional risks that traditional funds might not incur such as investing in derivatives and commodities,
and from the use of leverage. Absolute return funds are not intended to outperform stocks and bonds during strong market rallies.
5
Q1 2016 | Four strategies for a world of uncertainty
PURSUE
GREATER
RETURNS
In fluid markets,
flexibility is your friend
• Even in challenging markets, stocks alone give investors the high-performance
potential to achieve major financial goals.
• Girding a stock portfolio for uncertainty means using active strategies that offer
valuable risk-management flexibility.
• In a slow-growth world, selection strategies should focus on earnings and
balance-sheet strength.
Low economic growth, rising geopolitical instability, and elevated financial market volatility —
in short, the conditions seen over and over again in the past decade — can give any investor
reason to consider staying away from the equity market. Still, big financial goals may require
the sort of returns that no asset class besides stocks has historically provided.
We believe investors can invest in stocks with confidence despite the headwinds slowing the
global economy. And in choppy markets, we believe that active investment management is
quite valuable. When clouds appear on the horizon, equity analysts take a second and third
look at their assumptions about the stocks held in a portfolio, and change positions if needed.
Choose earnings and balance sheet strength
At Putnam, our fundamental equity research operates on the belief that over longer time frames,
earnings matter most in the determination of stock prices. That is why we spend the bulk of our
time trying to get the earnings picture right while analyzing companies from many angles.
Of course, earnings are not the only factor we consider. In today’s sluggish growth environment in
the global economy, we are also focused on key facets of company strength, including balancesheet flexibility, market-share advantage, and superior technological attributes. Perhaps not
surprisingly, such health is not currently in abundance in U.S. or non-U.S. markets — which is
another reason why we consider active selection strategies to be so valuable.
6
Putnam Investments | putnam.com
What drives a company’s earnings?
Fundamental stock analysis focuses on four potential sources of earnings growth.
SALES
MARGINS
P
• roduct penetration in
existing markets
I• nput or manufacturing costs
N
• ew geographic markets
BALANCE SHEET
OTHER FACTORS
M
• arketing or labor costs
C
• hanges in debt levels
or interest exposure
C
• onversion of earnings
to free cash flow
P
• rice increases
R
• efinancing opportunities
A
• cquisition possibilities
N
• ew business segments
P
• roduct pipeline
R
• eturn of capital to
shareholders
M
• acroeconomic factors
M
• anagement changes
Making progress in tough terrain
At Putnam, we believe that investing is inherently an
active endeavor. Accordingly, we view market dislocations
as opportunities and as particularly good occasions to
get back to the basics of fundamental analysis and active
decision-making.
As the 2007–2008 financial crisis fades more and more
into history, the road ahead remains complicated.
The worldwide debt burden remains largely unchanged,
economic growth is fitful, and central banks continue to
experiment with policies. For markets, the next five years
could easily be more volatile than the previous five years.
We also believe that challenging market conditions are
inherently an effective catalyst for better innovation — for
devising approaches that can keep up with the market’s
transformations, including changing regulatory frameworks as well as evolving economic and market realities.
Across asset classes, investment styles, and investor
needs, we offer new ways to manage risk, to find exciting
investment opportunities, and to strive to meet or exceed
the investment objectives of your clients.
Investors, we know, lack the luxury of waiting for better
conditions, and so we seek to approach these challenges
head on, to identify whether new sources of opportunity
may be veiled by genuine risks or by exaggerated headlines. The question to ask is which risks are the best ones
to take, relying on fundamental research to identify which
offer the most attractive compensation or can provide
beneficial balance to a larger portfolio.
No one can choose the challenges history presents, but
everyone can decide how to respond.
7
Visit putnam.com for market updates,
expert insights, and investment commentaries.
Find us
The views and opinions expressed are those of Putnam
Investments as of May 2016, are subject to change with market
conditions, and are not meant as investment advice.
Diversification does not guarantee a profit or ensure against loss.
It is possible to lose money in a diversified portfolio.
Consider these risks before investing: Allocation of assets among
asset classes may hurt performance. Stock and bond prices may
fall or fail to rise over time for several reasons, including general
financial market conditions, factors related to a specific issuer
or industry and, with respect to bond prices, changing market
perceptions of the risk of default and changes in government
intervention. These factors may also lead to increased volatility
and reduced liquidity in the bond markets. International investing
involves currency, economic, and political risks. Emerging-market
securities carry illiquidity and volatility risks. Investments in
small and/or midsize companies increase the risk of greater price
fluctuations. Growth stocks may be more susceptible to earnings
disappointments, and value stocks may fail to rebound. Funds that
invest in government securities are not guaranteed. Mortgagebacked investments, unlike traditional debt investments, are also
subject to prepayment risk, which means that they may increase
in value less than other bonds when interest rates decline and
decline in value more than other bonds when interest rates rise.
Bond investments are subject to interest-rate risk (the risk of bond
prices falling if interest rates rise) and credit risk (the risk of an
issuer defaulting on interest or principal payments). Default risk is
generally higher for non-qualified mortgages. Interest-rate risk is
greater for longer-term bonds, and credit risk is greater for belowinvestment-grade bonds. Unlike bonds, funds that invest in bonds
have fees and expenses. The use of derivatives may increase these
risks by increasing investment exposure (which may be considered
leverage) or, in the case of over-the-counter instruments, because
of the potential inability to terminate or sell derivatives positions
and the potential failure of the other party to the instrument to
meet its obligations. You can lose money by investing in the fund.
In the United States, mutual funds are distributed by Putnam Retail
Management.
Investors should carefully consider the investment objectives, risks, charges, and expenses of a fund before
investing. For a prospectus, or a summary prospectus if available, containing this and other information for any
Putnam fund or product, call your financial representative or call Putnam at 1-800-225-1581. Please read the
prospectus carefully before investing.
Putnam Retail Management
Putnam Investments | One Post Office Square | Boston, MA 02109 | putnam.com
SU848 300860 5/16