Along the distribution curve of possibilities, highly improbable events, so-called "tail events"—or "black swans" as they are popularly known today—do sometimes occur and can leave investors with either unexpected losses or, more happily, unexpected profits. (We think the latter outcome would be more appropriately referred to as a "golden goose.")

In either case, investment approaches are often reviewed following these periods. For example, after the financial crisis of 2008–09, risk-averse investors abandoned equities for bonds, certainly a well-established response to market uncertainty. But in a period of historically low interest rates, these investors may be exposed to negative real returns or even market losses. And when the economic environment improves and markets turn more positive, they are ill-positioned to benefit. Clearly, a return to a more balanced portfolio, with increased equity sensitivity, would be preferable when rates rise and inflation picks up.

There are many ways to add equity exposure to a portfolio. It doesn't have to be an "all or nothing" proposition. Robert Fetch, Lord Abbett Partner & Director of Domestic Equity Portfolio Management; Christopher Towle, Lord Abbett Partner & Director of High Yield and Convertible Securities; and Steven Lipper, Lord Abbett Allocation Strategist, explain further.

The future investment landscape will depend on the resolution of the various uncertainties facing investors, which include the long-term effect of loose monetary policies, the sustainability of U.S. economic growth, and the European debt situation, among others. Underlying these issues is the concern that a "Lehman-type" event could occur that would spark another bout of extreme volatility for equities and other high-beta assets.¹

The recent passage of several milestones from the 2008–09 financial crisis, however, indicates that subsequent calamities are not the only possible outcomes to the current issues facing investors. And considering the potential for rising interest rates and accelerating inflation, positive resolutions may present significant risks to investors who have increased their fixed-income allocations at the expense of their equity holdings, according to Robert Fetch, Partner & Director of Domestic Equity Portfolio Management.

"Investor sentiment remains biased against stocks at the potential cost of ignoring their benefit to a portfolio while overlooking the growing risks from fixed-income assets that have recently gained in popularity," he said. Investors contemplating the range of future risks may want to consider strategies that can add equity exposure and provide more balance to a portfolio amid an investing landscape fraught with uncertainty.

Given this uncertainty, many investors have braced for the occurrence of "tail events"—that is, the emergence of unexpected outcomes—and recent capital market movements provide a good example of this preparation.² At one end of this polarization, for example, was an S&P 500^® Index³ that traded near a four-year high of over 1,400 on May 1, 2012, and at the other end was the 10-year Treasury note that yielded less than 2% at the same time (see Chart 1).

This indicates that, "in one way, the markets have responded to the potential solutions to a problem, and in another, they have responded to the potential for subsequent crises," according to Christopher Towle, Partner & Director of High Yield and Convertible Securities.

The two tails of the bell curve
For investors concerned about the possibility of another Lehman-type event and its effect on risk assets, the equity market's performance during Lehman Brothers' journey through bankruptcy protection could provide some perspective.

After all, the investment bank's collapse in September 2008 and the market turbulence that followed were two of the defining events of the financial crisis. But by the time Lehman concluded the largest Chapter 11 case in U.S. history in early March 2012, the S&P 500 had more than doubled over the prior three years. And a month later, the S&P 500 Total Return Index,⁴ which includes reinvested dividends, reached an all-time high.

Prolonged outflows from equity strategies, however, suggest that many investors limited their participation in this performance following their conspicuous transition out of stocks. While understandable, this reaction indicates investors' tendency to overlook the potential for positive investment outcomes following a negative event that leaves a lasting impression.

Another example of a positive, perhaps unexpected, outcome for equities and other high-beta assets was from the European Central Bank's (ECB) long-term refinancing operation (LTRO). Although the program's three-year loans of more than €1 trillion were not regarded as a solution to the eurozone's problems, they relieved the most acute funding pressure on the region's banking system at the time. This support contributed to an equity rally that started in late 2011 and persisted until the second quarter of 2012 (see Chart 1).

While significant volatility could continue to emanate from Europe following the political developments in the spring of 2012, "the markets have been quick to discount some of the European outcomes," said Fetch. After all, two significant concerns at the outset of the debt crisis—a sovereign default and regional economic contraction—have already occurred as events with relatively little global fallout thus far.

Indeed, Greece's recent debt default and the resultant triggering of credit default swaps caused but a ripple across the capital markets. In keeping with the theme of uncertainty, however, it remains to be seen whether a Greek departure from the eurozone would lead to a similar result. And while the austerity measures initially designed to stem the tide of the crisis will likely lead to economic contraction within the eurozone in 2012, this has done little to alter expectations for global and U.S. gross domestic product (GDP) growth in 2012 of more than 3% and 2%, respectively.⁵

While U.S. economic growth is expected to remain gradual at about 2% this year, there are segments of the economy that have expanded faster than might have been anticipated during the depths of the recession. For example, domestic manufacturers have continued to adapt to the postcrisis environment, as they have taken advantage of rising emerging market demand, declining natural gas prices, and improving productivity.

Considering these advantages, the profits for U.S. manufacturers not only have recovered to their precrisis level, but also have reached a record of nearly $600 billion in 2011, according to the U.S. Census Bureau. The surge in profitability has also been accompanied by a similar trend of rising profit margins, which underscores the effect of these manufacturing advantages in an environment of inconsistent demand.

With manufacturing emerging as an industry that could propel future U.S. economic growth, sectors that have limited the pace of the recovery, such as real estate, are poised to act as less of a drag or to start contributing to the expansion. From a capital markets perspective, the stabilization in residential and commercial real estate has been reflected by the strong demand for former AIG assets that were at the forefront of the financial crisis and subsequently acquired by the New York Federal Reserve as part of the insurer's $182 billion bailout.

Although the investment banks that purchased AIG's former assets did so at notable discounts, their increased demand reflects the yield-starved environment and their relative comfort with securities that were packaged near the peak of the real estate bubble. This is another indication that "we've probably seen the worst of the housing declines to where the housing market will no longer be a negative drag on the economy," said Fetch.

As these various issues evolve, so too has the role of global monetary policy in attempting to bolster economic growth with both conventional and unconventional methods, such as quantitative easing. This latter tactic has pumped an enormous amount of liquidity into the financial system that has influenced the capital markets. While the markets' response to this liquidity may be encouraging to policy officials, it has probably fallen short of their intended goal of establishing a sustainable economic recovery. One measure reflecting the liquidity’s stagnation in reaching the real economy is that, by the third quarter of 2011, the velocity of the money supply fell to its lowest level since 1959.⁶

There are recent indicators, however, that could eventually push some of this liquidity toward consumers and businesses, as bank lending for real estate and commercial and industrial loans has rebounded after a steep decline during the recession (see Chart 2). A stabilization or acceleration in the velocity of the money supply via increased bank lending would reflect more consistent economic growth and further support for the equity market.

For investors with significant weightings of high-quality bonds, however, an increase in the velocity of money could lead to faster inflation given the huge expansion of the money supply over the past several years. And it would not take much more inflation to generate negative real returns on a variety of fixed-income securities. While the Federal Reserve's pledge to keep short-term interest rates at "exceptionally low" levels until at least late 2014 could contribute to accelerating inflation, higher prices may eventually require higher interest rates as well. This poses another potential threat to investors who have shifted into fixed income and away from stocks, which have historically provided a partial hedge against faster inflation and rising interest rates.

The potential for what could be a positive economic outcome from the current monetary policy initiatives "indicates that there is significant potential for price declines on bonds with a high degree of interest-rate sensitivity," said Steven Lipper, Allocation Strategist. "This indicates that the relative risk of stocks compared with high-quality bonds could be considered relatively low."

Multiple methods for more balance
The possibility of accelerating inflation over the long term is another outcome that supports the rationale of suitable equity exposure, considering that stocks—and therefore, corporate profits—have historically demonstrated a tendency to keep pace with inflation expectations (see Chart 3). Yet, in an environment where investors remain wary of stocks, while recognizing their potential benefits, they still face the dilemma of how to increase their equity exposure as conditions continue to shift.

There are measured approaches to increasing equity exposure, however, that historically have delivered certain results that investors may find appealing in the current environment. In terms of adding pure equity exposure to a portfolio, the universe of value stocks has posted less volatile returns compared with growth stocks over the past 20 years.⁷ This historical attribute may be of interest to investors, even though growth stocks recently have outperformed value stocks.

A value strategy that is focused on minimizing risk may be another attractive attribute for investors seeking additional equity exposure. "Our approach tries to emulate the 'win by not losing strategy,'" said Fetch, who has honed this approach over 35 years of investment experience. His process involves identifying stocks that appear undervalued based on several metrics and identifying corporations that have positive catalysts that can lead to equity-price appreciation. The goal is to construct portfolios consisting of holdings with both upside and downside price targets, favorable reward-to-risk ratios, and, importantly, limited price risk.

This conscientious approach to risk management can be the overriding factor in an investment decision, according to Fetch. "In addition to investing in high reward-to-risk stocks, this also means avoiding those with high reward potential if their risks are unacceptably high as well."

Within the broader universe of value stocks, mid cap value stocks have performed particularly well, as they have beaten the broader U.S. stock market in about three-quarters of the years between 1986 and 2011.⁸ Yet these stocks also tend to have a higher level of volatility than large cap stocks, which may be an unattractive prospect for investors looking to wade back into equities.

When mid cap stocks have been combined equally with convertible securities, however, this pairing has presented historical returns better suited to weather a variety of market conditions. Indeed, the combination posted a 10-year annualized return through 2011 of more than 6.0% and a standard deviation of less than 15.5%. This was more than double the return posted by the S&P 500 Index—but with less risk (see Chart 4).

The concept of pairing asset classes to gain the desired investment potential can be replicated in several ways, according to Lipper. "Each asset class has a respective risk profile, and we believe that certain combinations of asset classes can moderate the overall volatility of equity exposure while continuing to seek attractive income and capital appreciation opportunities."

For investors seeking equity exposure in an income-oriented strategy, convertible securities could again come into play. And their use can be of particular value if analysis reveals mounting inflation pressures. In that case, "we would look to the convertible securities of materials, energy, and industrial companies. These securities can provide exposure to the movement in commodity prices, as well as to industrial companies that have pricing power at the sales level," said Towle.

The prospects for accelerating inflation and eventually higher interest rates do not mean investors should abandon all fixed-income asset classes. Indeed, high-yield bonds have historically moved in the same direction as equities, but to a lesser extent. This is because an environment of rising interest rates is often accompanied by strengthening economic conditions, which can strengthen the credit quality of corporate borrowers and lead to tighter credit spreads. For example, as of late April 2012, the 10-year Treasury note had posted a loss of about 3% or more in six quarters since 2004, and high-yield corporate bonds posted positive returns in five of those quarters.¹¹

More recently, the 10-year Treasury yield surged from a low of 1.99% to 2.39% during the period of March 12–19, 2012, which led to a loss of 3%. During that same period, however, the high-yield bond market posted a positive return of more than 10 basis points, as high-yield credit spreads tightened. There is no guarantee this trend will continue in the future, but it shows that as one moves on the risk spectrum toward equities, certain securities move more in sync with stocks.

While it is a common reaction to move toward assets that are perceived to be the least risky following periods of volatility, the current environment has created some irony to that approach. "When investors discuss equities, many say, 'Well, you know what happened a few years ago.' This sentiment encapsulates what investors may be feeling in terms of expecting some negative scenarios, while being unprepared when a positive event occurs," said Towle.

Indeed, the traditional methods of reducing volatility by investing in high-quality fixed-income assets may, in fact, expose investors to the risks of negative real returns or market losses due to the current environment of historically low interest rates. Yet, they should not view a larger equity allocation as an "all or nothing" proposal, considering that there are multiple ways to increase equity-like exposure and achieve the benefits that a more balanced portfolio may provide in an era of uncertainty.