Rudi's View | Jun 05 2013
By Rudi Filapek-Vandyck, Editor FNArena
What has been the single most important change that has occurred during the past three decades?
It was not the emergence of China and other BRIC economies. It was not the invention and popularisation of the Internet. Nor has it been the deployment of quantitative easing by major central banks.
It has been the steadfast decline in global bond yields from high teens percentages in the seventies and eighties to near zero, or even negative, today.
There is more than just a fair argument to be made this downward trend has been responsible for the many product innovations in the global finance sector, for possibly the strongest bull market era for equities in history, and for unusually high investment returns in general.
The problem is, this process has now largely run its course and it seems only fair to describe the current era as a period of transition whereby, at some point, global bond yields shall rise to higher levels.
Given falling yields have provided so many tail winds for such a long time, it follows that rising yields will be replacing these tail winds with head winds.
Result number one is many major wealth managers across the globe have started to prepare their clientele not to expect the same investment returns in the decades ahead as we've all witnessed and experienced in the decades past. A large group of these clients is now rapidly approaching retirement and with two major bear markets for equities in the past twelve years still leaving mental scars, these customers are giving feedback they do no longer wish to take on board the excessive risks from the past.
Consequence number one: the traditional balanced funds approach whereby 70% goes into equities and 30% into (government) bonds no longer applies.
Most government bonds in developed countries offer little or no yield and are at risk of a major sell-down, thus offering a lot of risk and hardly any return. These bonds are likely to provide investors with a negative return in the immediate years ahead.
But are equities really the logical alternative? After all, the sell-offs and subsequent bear-markets of 2000-2003 and of 2007-2009 are still fresh in everybody's memory. Who wants to take on board such risks when retirement is approaching?
If these, and other, considerations have been on your mind -be it as a manager, an advisor or an investor- you are definitely not alone. A recent new product launched by Russell Investments and a new global study by AMP Capital and the Institutional Investor Custom Research Group have revealed that this time, really, times have changed and there's going to be many consequences, not the least for the financial industry itself.
First, allow me to point out that on numbers generated by Australia's own expert demographic researcher, Bernard Salt, the retirement of the baby boomers generation is expected to accelerate from here onwards with some 120,000 new retirees coming of age, so to speak, in each of the coming years compared with the already higher than usual 43,000 per annum that have been quitting the jobs force in recent years.
This will rapidly lead to the formation of a vocal group of consumers and investors which will demand new products and services. One of these demands relates to the preservation of the current life style. In financial terms: investment returns and income but with lower risk.
The new trends are already here. Investors do not have to look any further than the inaugural issue of the AMP Capital Institutional Investor Research Report, released last week. In a nutshell the new trends are:
– Significantly less equities
– Significantly less commodities
– Significantly less risk
– Significantly less developed countries' government debt
– Significantly less cash
– Significantly more alternatives
The addition of trend number six seems but obvious, because if all the first five are being reduced, something else not yet on the list should inevitably become the new beneficiary. I thought I'd point it out nevertheless, if only to emphasise the fact that investors worldwide have had enough of the traditional portfolio constructions and the related risks and disappointments.
Consider, for example, the latest innovation by Russell Investments (I will talk more about it further below) suggests a reduction of the traditional 70% equities exposure to a maximum of 50% only. Were this to be adopted industry-wide, across the globe, this would imply major consequences for equity markets and those for who live off them. Not to mention the fact that "cash on the sidelines" today remains one of the reasons why many equity experts are so excited about the future outlook for global stocks.
The AMP study, which comprises of large domestic and international pension funds managers and of others such as insurers and sovereign wealth funds, draws the same conclusions: "We find that investment decision-makers at large institutional investor firms are most likely to have increased allocations to alternative asset classes in recent months, and that they are likely to continue to do so in the future."
Before I explain the how, why and what behind the "alternatives", there are a few important observations I want to share with regards to the "equities" and the "bonds" components in the new asset allocation trends (I am combining info from Russell and AMP plus some other input sources for this).
Every smart investor should have figured out by now that government bonds in the US and in Europe + UK and in Japan are simply not worth the risk of owning other than for purposes of short term trading techniques. The fixed income allocation in investors' portfolios is thus switching towards corporate debt and towards debt in emerging countries. Another new, popular yield instrument is infrastructure debt. Think a corporate bond issued by the likes of Sydney Airport ((SYD)) or Transurban ((TCL)). But investors no longer feel constraint to go outside listed entities, so if an unlisted entity such as Snowy Hydro Ltd would want to raise capital through non-listed debt, global demand will be virtually guaranteed.
Here's another conclusion to digest: while many an equities specialist has been predicting the Great Rotation, out of bonds and into equities, current trends around the world suggest this phenomenon may actually never happen as investors in general, and bond investors in particular, are already looking for, and finding, alternatives outside traditional markets. Maybe the Great Rotation should be given a different meaning (see also below)?
When it comes to "equities" there are two straightforward, major observations: domestic stocks are seen as less attractive than international peers (in particular US equities and emerging markets) and inside the group of equities, less risky, solid income generating stocks are preferred above higher risk, no income generating stocks.
In FNArena-lingo, and this became in particular clear during the investor conference and media presentation organised by Russell Investments last week, all this translates into: All-Weather Stocks(*) are very much "in", as are reliable, solid dividend payers.
Some commentators elsewhere have blamed the sheer obsessive focus on dividend stocks in the Australian share market over the past nine months or so solely on the growing trend towards more independent SMSFs ("smurfs" as we call them). Well, they're wrong. The new trend extends far beyond a growing piece of the pie for SMSFs in Australia and it is about seeking out the more solid, less volatile, income generating, less risky opportunities in equities, without feeling sorry for not fully capturing the upside of the next rally at the more risky end of the market.
In practical terms, the new equities trend can be summarised as: more Ramsay Healthcare, less Atlas Iron. More Ardent Leisure, less Pharmaxis. More Commonwealth Bank, less Fortescue Metals. More McMillan Shakespeare, less APN News and Media. More Invocare, less Fleetwood.
One of the stand-out admissions by Russell Investments last week is the fact it is no longer seen as a deadly sin to underperform the index. Russell's Multi-Asset Growth funds, shortcut MAGs, aim to deliver consistent growth at lower risks, which implicitly means investors should both miss out on peak-performances as well as escaping trough-returns (even though Russell acknowledges these funds might not necessarily have remained in positive territory throughout the Big Sell-Off of 2008).
But if simply following the index for equities and allocating 30% to government bonds no longer applies as a suitable strategy given both the general investment context as well as clients' needs have changed, what then are the "alternatives" ?
Here both Russell Investments and the AMP survey have revealed a few genuine surprises. Obvious alternatives are real-estate, both listed and unlisted, infrastructure, both listed and unlisted (as well as including infra debt instruments, as mentioned earlier), next to private equity and hedge funds. The AMP survey has revealed there's also a growing appetite for direct investments, thus without an intermediary. Direct property. Direct infrastructure. Even direct commodities. Those who have kept their eyes and ears wide open during the year past would have picked up examples for each of them.
Here's another telling observation from the AMP report: "Investments in alternative asset classes doubled from 2005 to 2011, as AUM [Assets Under Management] in alternative assets grew seven times faster than in traditional assets, according to McKinsey’s 2012 study, The Mainstreaming of Alternative Investments. Clearly, with $6.5 trillion invested in alternatives, this asset class has become part of the institutional investment mainstream."
The real innovations are centred around income generating assets. This is why wealth managers are no longer by definition afraid of owning illiquid assets, such as direct property, because such assets can be sources for reliable, steady income without the volatility that gives clients the heebie jeebies. This focus on low volatility returns/reliable income also explains the absence of gold, or any commodities in general.
In the universe of Russell Investments, alternatives also include sophisticated trading strategies, such as playing the curve in bond markets, pairs trading in equities, writing stock options, adding currency hedging and trying to benefit from temporary valuation distortions (this includes going short). Equally important is that in specific strategies and assets where there is no in-house expertise, Russell will scour the globe and try to find a specialist that can do the job at reasonable cost.
Above all, the new key word is "flexibility". There's no value in operating through an inflexible mandate if this means having to allocate more funds to an asset that is either overvalued or about to crash. Defensive stocks overvalued? Maybe it really is time to broaden the allocation to a little more risk, for now. Equities going nowhere? Time to look elsewhere then.
Within this framework, Russell Investment specialists indicated they still like corporate debt, are very much in favour of emerging markets (both debt and equities) and will add more unlisted and illiquid assets if wholesale clients are comfortable with this.
The AMP survey indicates institutional investors remain focused on expanding into new asset classes (37%) and on further reducing risks (27%). This is not a temporary phenomenon. The growing army of baby boomer retirees will definitely act as the growing stimulus for ongoing product innovation.
Investors take note, if you haven't already.
To download the full AMP survey report: http://www.ampcapital.com/campaign/iir/quarter-1
For the latest Russell Investments product, see the corporate website
P.S. – The AMP survey suggests institutional investors have been withdrawing some funds from the Australian share markets and re-allocated some of it to emerging markets. Funny that is, our recent Australian Investors Sentiment Survey for May revealed retail investors have been withdrawing funds too, only to add to their cash on the sidelines levels.
P.S. II – Russell Investments markets its new MAGs product under the slogan "Equity-like returns, with lower volatility". When I specifically queried about what they have in mind for equity-like returns, the response was inflation plus 4% per annum on average (around 6% per annum before adjusting for inflation).
(*) DO YOU HAVE YOUR COPY YET?
At the very least, my latest e-Booklet "Making Risk Your Friend. Finding All-Weather Performers", which was published in January this year, managed to accurately capture the Zeitgeist.
All three categories of stocks mentioned in the booklet are responsible for the index gains post 2009 and this remains the case throughout 2013.
This e-Booklet (58 pages) is offered as a free bonus to paid subscribers (excl one month subs). If you haven't received your copy as yet, send an email to info@fnarena.com
(Do note that, in line with all my analyses, appearances and presentations, all of the above names and calculations are provided for educational purposes only. Investors should always consult with their licensed investment advisor first, before making any decisions. All views are mine and not by association FNArena's – see disclaimer on the website)
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Rudi On Tour in 2013
– I will present and contribute during the 2013 National Conference of the Australian Technical Analysts Association (ATAA) at the Novotel in Sydney's Brighton Beach, June 21-23
– I will present to members of AIA NSW North Shore at the Chatswood Club on Wednesday 11 September, 7.30-9pm