Thirty-five years ago, bond yields in the US were 15%; today globally they are routinely negative or very low. The path to this point has been, mostly, a relatively pleasant one as each time rates fall, valuations can improve and financial conditions can ease. That cycle is nearing its end as rates move to zero, although negative rates are maybe the next step.
Diversified fund performance reflects these trends with generally strong long-term returns. A typical diversified fund however, that would historically be expected to produce a return above 8 or 9%, is now looking at around 7 – 7.5%. The impact is worse for lower risk funds where greater exposure tends to be held in bonds and cash.
The immediate industry response may be to simply extend portfolio time horizons. APRA reporting standards have required longer horizons for some higher risk funds, and this would allow greater probability of success. A second response would be to communicate expectations to investors more clearly; most of us take bad news better if we are prepared beforehand. The third response is in thinking about how we manage portfolios.
What can portfolio managers do to help generate real returns?
We believe there are three key areas where portfolio managers can materially improve the potential for superior return outcomes.
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Greater flexibility in asset allocation
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Increased footprint in alternative return sources
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Being opportunistic
The effectiveness of these three strategies rises with the flexibility allowed in the portfolio construction. A holistically managed portfolio with few constraints around peers or benchmark exposures, and more flexibility with fees, has a greater ability to implement than a passively managed fund in a peer survey.
The flip side however, is that the greater the application of these strategies, the more a manager or company must invest in appropriately skilled staff, due diligence, systems and governance.
1. Increase flexibility of asset allocation – adopting a more dynamic process to respond to changing expectations
In years prior, when yields were higher, there was already a greater probability of achieving targets and therefore less incentive to actually do anything differently. Any type of asset allocation was less important simply because the additional value added was a smaller component of the final return. Today that is changing and any additional value-add is potentially a much larger component of the total.
When we talk about dynamic asset allocation we don’t mean short-term trading, we are really talking about the next few years and what current market conditions imply for returns over that period. This is far more than simply saying something is cheap or expensive and assuming some sort of reversion to a long-term valuation. It means also being aware of the cycle, liquidity and investor sentiment.
Global market returns have historically been defined by longer term ‘secular’ cycles lasting circa 5-20-years, and shorter-term business and market cycles lasting approximately 1-5 years. Each long-term cycle is normally born in a crisis and driven by a period of rapid innovation or productivity, and ends in a “blow out” in valuations and excess exuberance.
Within these longer cycles there are always business and market cycles as well, where valuations, cyclical trends and investor emotion drive markets. In a bull market these trends tend to get muffled, but in a bear market they are stark and provide an enormous opportunity relative to the passive long-term investor.
2. Search for other return sources to introduce greater diversity
One of the most advantageous additions to a portfolio is to have investments that are truly diversified. Markets offer diversification benefits to a point, but ultimately they tend to cluster around economic conditions. If growth is strong then credit and equities do well, if growth is weak bonds do well.
Identifying and gaining adequate exposure to ‘alternative’ return sources provides a rich vein of returns that should always improve portfolio outcomes, but in a low growth world offer additional potential value.
What is an alternative? Direct assets such as private equity or infrastructure are one avenue, albeit with loss of liquidity. These assets do offer more diversification given they are more about the actual asset and manager than about a broad market, but they are also affected by cycles, the ride is smoother (normally) because pricing and transactions are slower.
Another source of returns are in alternative strategies, or finding opportunities that offer good return potential but are much less dependent on markets. Often, this means moving from a world of direct holdings (what do I buy with my cash) to a relative world (what can hold relative to something else).
Consider the notion of value. Most share managers around the world incorporate the idea of buying ‘cheaper’ stocks. Most academic studies identify ‘value’ as a persistent return factor, i.e. where consistently buying cheap stocks and not owning expensive stocks yields a premium in return over the broader market. Lastly, many return studies identify a value bias as explaining a large portion of the average performance of active value managers. So we are probably already exposed to it but may not be aware of what we are really paying for.
There are many different types of alternative strategies that can be accessed in global markets. Identifying those that can be profitable, and when, is the challenge. Avoiding those that aren’t persistent, or are arbitraged away, or are simply too expensive to capture, is the challenge that must be overcome.
3. Be opportunistic
Perhaps the hardest solution is to simply be more opportunistic. The idea is that there are always dislocations and opportunities in markets that can provide excess return potential.
Examples abound, particularly when liquidity has left smaller markets. Think inflation linked bonds in 2008, leveraged loans or convertible bonds in 2009, peripheral European debt in 2012, non-agency mortgages in 2012 and 2013. Some markets get crushed when everyone has to exit and there is no natural buyer except the brave and well informed. Oil volatility for example rose spectacularly in the third quarter of 2015 after a period of relative stability. On occasion the dislocation can be very fast, US Treasuries in October 2014 provided a very brief opportunity to react with an intraday crash that lasted minutes.
A good example is in 2008 when the US inflation-linked bond market collapsed. These securities, known as TIPS, offer a yield that is in part linked to inflation. Normal government bonds offer a yield that reflects expectations of inflation. The difference is called the breakeven rate, i.e. if inflation is above the breakeven then TIPS outperform, if inflation is below then normal (or nominal) bonds do better.
What is likely to be more common in the future is an evolution in the way investment managers work with clients and also with each other, to allow differentiated opportunities to get into portfolios. We are already seeing this with ‘partnering’ becoming an increasingly common term. The idea is that we work with external specialists to bring ideas and insights that can be implemented in a portfolio, rather than be given a mandate to just manage bonds (for example).
What can investors do?
Given the outlook for returns over the medium term, investors – particularly those in or nearing retirement – can take steps to help ensure their investment portfolio seeks to deliver the real returns they need to support their retirement income.
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Have reasonable return expectations
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Potentially be prepared to take more risk in order to receive higher returns
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Ensure investments are diversified
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Look for investments that are flexible in their approach and are actively managed
More information
If you would like to know more about AMP Capital’s goals-based approach to investing, please visit Goals-based Investing.
Important note: While every care has been taken in the preparation of this article, AMP Capital Investors Limited (ABN 59 001 777 591, AFSL 232497) and AMP Capital Funds Management Limited (ABN 15 159 557 721, AFSL 426455) makes no representations or warranties as to the accuracy or completeness of any statement in it including, without limitation, any forecasts. Past performance is not a reliable indicator of future performance. This article has been prepared for the purpose of providing general information, without taking account of any particular investor’s objectives, financial situation or needs. An investor should, before making any investment decisions, consider the appropriateness of the information in this article, and seek professional advice, having regard to the investor’s objectives, financial situation and needs. This article is solely for the use of the party to whom it is provided.
