What Portfolio in Europe Makes Sense?

Abstract

This article focuses on European bond and equity portfolios, and specifically the relevance of balanced portfolios. European equity and bond markets have undergone tremendous changes since the launch of the European Monetary Union (EMU) in 2000. Describing the risk–return profile of these markets provides valuable information about past structure and historical returns and shifts the focus onto future expectations for institutional portfolios. The great volatility and low returns involved in European equity markets are a possible explanation for why investors prefer bonds that show Sharpe ratios higher than one. Taking into account five-year realized inflation, as well as strong bond market performance in the past 20 years with yields in the negative territory, the evidence indicates that the window for expected returns on balanced portfolios with large bond exposure is firmly shut. There are two challenging issues for European portfolio allocation. The first reflects the future of bond exposure in a balanced mandate. The second involves meaningful allocation to equity markets in a balanced portfolio.

TOPICS: Security analysis and valuation, fixed income and structured finance, developed markets, portfolio construction

Key Findings

• ▪ European bond markets have performed excellently in the last 20 years because of investor demand, capital inflows, and growth. The European bond market dominates in institutional portfolio allocations, and equity markets have been less attractive, given their risk–return characteristics.

• ▪ In a negative yield environment and where real equity returns are expected to be positive, it is questionable whether balanced allocation is capable of generating the desired financial outcomes. Foreign exchange, emerging market bonds, and global equities might provide desired returns for investors.

• ▪ Two challenging issues are involved in European portfolio allocation. The first reflects the future of bond exposure in a balanced mandate. The second involves meaningful allocation to equity markets in a balanced portfolio. Diversification has not disappeared, but finding expected returns might be challenging.