Constructing an effective investment portfolio that will perform through the investment cycle is a challenging task at the best of times. This task has become significantly more difficult in recent years as interest rates have settled to near zero levels.
A long-held strategy of constructing portfolios for retirees has been to hold 60% in Equities and 40% in Bonds. This has served investors well as bond returns have delivered the goods when equities falter and interest rates have been reeled back in.
The problem we face now is that the running yield on bonds and credit is wafer thin and any increase in rates will devalue most bonds with any interest rate duration. To further complicate things, many investors have sought out riskier investments as they have become frustrated with super low returns on many fixed interest investments.
So what we are faced with today is a very low interest rate environment and an equity market that is priced at high valuation multiples – this is a tough investment environment.
The high equity market valuation is really a product of the low interest rate environment. The reasons are twofold. Firstly, low interest rates have forced many investors from their ‘safe haven’ fixed interest investments into equity market investments. Secondly, low interest rates inflate equity market valuations, as investors use a very low ‘discount rate’ to value their shares.
With high share valuations and the real risk of interest rates heading higher in the period ahead, one really has to challenge the old 60/40 portfolio theory. What we could see happen in coming months is a scenario where interest rates rise at an uncomfortable pace leaving equities and bonds in negative territory. That ballast that bonds have provided in past periods might not be there and both asset classes could suffer negative returns in tandem.
Many investors see the choice between bonds and equities as a binary decision, but in reality there are many options available to tackle this problem.
However, before we look at some effective ways to tackle this problem, lets look at some arguably faulted strategies we see being used today:
Chasing yield
One of the more concerning strategies we have witnessed is investors chasing higher interest rates to compensate for ultra-low interest rates. In simple terms the higher the interest rate offered the higher the credit risk and the higher the chance of losing capital in a loan default. Most fixed interest investments have a credit rating and once that rating falls below BBB, it is classed as Junk (or sub investment grade). What concerns us is the huge volume of BBB paper sitting out there and the wafer thin credit spreads offered to investors. It doesn’t seem like a good risk reward trade off and chasing that extra 1 or 2% return could come at a significant cost.
Increasing risk
Another trend we are seeing is a binary switch from defensive asset classes in fixed interest to high risk equities. Whilst this has been a good trade so far, with equity valuations rising strongly post COVID, it does leave investors at the mercy of equity markets which are significantly more volatile and now trading at historically high valuation levels.
Staying the course with 60/40
The biggest trend however is the ‘do nothing’ crowd. We see so many model portfolios and standard portfolio offerings in managed accounts and the like where the old 60/40 portfolio construct remains in place. High equity valuations, ultra low interest rates and a trend for rising rates now leave this approach vulnerable to a low return outlook for years to come.
None of these strategies hold much appeal to us, so we have spent considerable time and effort in rethinking the makeup of our portfolio construction processes. What we have resolved is a multi layered strategy which includes:
· Increasing exposures to ‘Alternative’ asset classes
· Increasing exposures to high quality assets in the global infrastructure sector
· Identifying differentiated equity investment strategies
· Reducing exposures to index large caps
· Retaining high quality fixed interest investments
· Reducing interest rate duration exposures
By re-designing the Growth component of portfolios to include infrastructure, alternatives, and more differentiated strategies, we believe that there are better risk adjusted return prospects than an equity index approach. This allows a higher allocation to the growth component without the raw effect of simply switching bonds for shares.
It’s worth taking a closer look at each of the above steps in our strategy:
Alternative Asset classes
Alternatives can include all manner of investments. Unfortunately many of them are opaque and difficult to understand – and often referred to as ‘black boxes’. We avoid these types of strategies and have focused primarily of two types of Alternatives, namely Real Return and Absolute Return strategies.
Real Return strategies are multi asset investments which include a wide range of both defensive and growth investment classes. The Manager often has a mandate to switch between the asset classes as they see fit depending on where we are in the investment cycle and what investments offer the best risk adjusted returns at the time – a process referred to as Dynamic Asset Allocation. Returns from these types of investments are usually a little lower than those of equity market returns, but the volatility is significantly lower. We see these types of investments perfectly suited to challenging markets we see today.
We target Absolute Return strategies that are not correlated to traditional equity market returns. The Funds we use are market neutral funds. Whilst the funds invest almost entirely in equities, the net exposure is always close to zero, so you aren’t exposed to the direction the share market is heading. Instead, your risk is more aligned to the skill of the investment management teams who are managing a book of long and short equity positions. The returns from these funds are expected to be similar to that of share funds, with low levels of equity market correlation and an overall lower volatility level.
Global Infrastructure
High quality infrastructure assets are solid investments. We target funds that invest in essential infrastructure assets in the transport, energy, communication, and utilities sectors. These assets are usually monopolistic, they are long life assets most of us are compelled to use every day, they are often regulated and many of them have charging contracts that are linked to inflation. Australians are somewhat used to investing in these types of assets, but elsewhere in the world, the asset class is just taking off and the global demand from large pension funds, and sovereign funds is increasing at pace. This is reflected in the number of quality infrastructure assets low listed on the ASX (only 2 or 3 compared to over a dozen just a few years ago). Investing in such crucial long life assets makes a lot of sense, particularly when many of them have inflation linked income streams.
We find a significant allocation to global infrastructure compliments our equity holdings well and adds significant diversification and resilience to our Growth investments.
Differentiated Equity Investments
In an investment world where everybody seems happy to hug an index, we feel that this somewhat lazy approach to equity investing will leave many exposed to excessive market valuations and overweight exposures to very large, slow growing companies. As an example the ASX300 is a very top heavy index with the top 10-12 stocks making up around 2/3’rds of the whole index. Five banks, two supermarkets, three miners, a big telco and a healthcare company make up the bulk of our index and arguably only two of those companies have provided attractive returns over the last decade.
Whilst we do hold some index positions in our portfolios, we have many more exposures to differentiated equity market strategies which include specific investing styles, like ‘value’ and ‘growth’, we have specialists in small and mid cap companies, have funds with strict valuation disciplines, and others with long/short strategies, strong investment thematic, and even a fund with downside protection against major market downturns.
Climate change policy is one thematic which will throw up a significant opportunity set where well placed companies will be major winners and will grow well above system over the coming decades.
Importantly we overlay a ‘quality’ philosophy to fund selection to ensure that whilst we employ a range of styles and investment approaches to equity investing, there is an overall focus on investing in high quality businesses.
We believe that selecting the ‘best of breed’ investment teams across a range of differentiated styles will deliver improved risk adjusted returns in equities through the investment cycle.
Reducing Exposure to Large Cap Equities
Whilst index investing (usually by way of ETF’s) has grown exponentially over the past decade the result has been a concentration of capital in the largest companies in most indexes. This in turn has driven up valuation as the crowd all descend upon the same investment approach.
Whilst this will remain problematic for set and forget index investors, exposed to high levels of volatility and elevated valuations, we feel validated in our approach to re-weight away from mega and large caps to smaller and medium sized companies where the opportunity set is significantly larger and valuations often more compelling.
Retaining High Quality Fixed Interest Positions
Rather than chase higher yielding higher risk fixed interest positions, we feel that the most important element of the defensive component of a portfolio is to provide stability, preserve capital, and remain highly liquid for future strategic investment opportunities. We don’t feel investors are appropriately rewarded for increasing risk in the yield chasing exercise.
Reducing Interest Rate duration
The average duration in a typical bond index is currently around 6 – 7 years. Every time interest rates have fallen the bond value has increased, but conversely as interest rates start to rise the value of these bonds will fall. Now predicting the future direction of interest rate movements is no easy task, but with rates nailed to the floor over the past couple of years, the risk of upward rate movements are now real. Index investors in this space are in for a real shock if rates start to climb.
Our approach is to have less than 20% of our total defensive position in interest rate duration positions (over 2 – 3 years). This part of defensive portfolio is actively managed and in highly rated securities so that any undue interest rate affects are not delivered harshly into overall portfolio outcomes. The majority of our defensive holdings are in zero or short duration positions and in securities with generally higher credit ratings.
Summary
Whilst the current investment climate of low rates and high equity valuations is a most challenging one, we feel that there remains an attractive opportunity set for the investment professionals who are prepared to search beyond the index and structure their investment processes in a strategic and thoughtful manner.
We too have felt compelled to rethink and redesign our approach to portfolio construction and feel that we are well placed to deal with the challenges that lay ahead.