The same emotions affect fixed income investors just as much as share investors, says Roger Bridges
The same powerful forces that drive share investors – greed and fear – also affect the behaviour of fixed income investors. The greed element was no more apparent than in the lead-up to the global financial crisis (GFC), with investors’ thirst for ever-higher returns in a low-interest-rate environment prompting many to invest (often unknowingly) in higher-risk “so-called” fixed-income securities. However, the tide has turned, with greed replaced by a prolonged period of fear, and investors now focused on the aftermath of the GFC – specifically Europe’s debt and banking problems, as well as doubts about the strength of the US economic recovery.
Investors are more worried about the return of their capital than the return on their capital. They are in turn tending to shy away from risk, preferring the comfort of good old-fashioned “safe haven” sovereign bonds (mostly US, Canada, Germany and Australia at present), sparking strong rallies in global bond markets.
In this article we provide insights into how the greed and fear emotions and associated investor behaviours can be tamed, or at least kept at bay. Recognising and understanding these behaviours is one thing, but changing them is something else.
As a fund manager, we are not completely immune to these behaviours; however, there are steps we take and disciplines that we adopt to help minimise their influence on our investment decisions. Essentially it comes down to one word – “process”. Having a process that sets boundaries and rules permits you to challenge the status quo and it stresses your biases; it allows you to have greater control over the greed and fear emotions, and ultimately make more rational investment decisions. In this article we share some of the Tyndall fixed income team’s secrets to successful investing.
The rise and fall of credit
Fixed income, specifically credit, has stolen the limelight in recent years as a result of the GFC and knock-on effects on world economic growth. The increased demand for, and supply of, credit in the late 1990s saw this sector grow rapidly as a proportion of the UBS Australian Composite Bond Index (Index), peaking at 36 per cent in 2006 (as shown in chart 1). Meanwhile, Commonwealth Government bonds declined sharply during this period, due largely to the elimination of the Federal Government’s budget deficit, which was replaced by a significant surplus.
In a post-GFC world though, the picture has changed. Credit issuance virtually came to a standstill in 2007-2009 with corporates unable to issue debt due to lack of demand, or their unwillingness to pay the yields required by investors.
Meanwhile, governments around the world increased their bond issuance to finance their stimulus spending. In Australia, credit as at May 2010 had fallen to around 17 per cent of the Index while Commonwealth Government bonds had risen to 28 per cent, with semigovernment debt and Supras making up the balance. (“Supras” are highly-rated sovereign and supranational issuers, and securities issued by banks, guaranteed by a domestic or foreign government.)
Index investing doesn ’t neces – sarily deliver the best risk /return
As an observation, in the early stages of the “de-risking” process, many investors sought the safety of index investing, perceiving credit securities to be too risky. The only problem with that, of course, is that at that time many bond indices had high exposures to credit securities – so investors weren’t necessarily escaping from the “bad” credit.
This raises one of the biggest downsides of index investing in fixed income – those companies that need to issue large amounts of debt end up representing the largest proportion of the Index, exposing investors to greater risk than they probably realise.
Index investing can only be justified if the markets are totally efficient. However, it is our belief that markets are not always efficient. Our experience shows that markets often incorrectly forecast short- and medium-term influences and conditions. As market participants respond differently to the information available, investment opportunities can arise when interest rates move away from their fair value, therefore creating the potential to add alpha.
From a portfolio construction perspective the Index is not an efficient portfolio, particularly in the current environment. As a result of the large amount of Australian government bond issuance that has taken place in recent times, the average credit rating of the Index is now close to AAA.
In chart 2, we estimate the Index (marked with an “x” on the chart) lies approximately half-way between AAA securities and Commonwealth Government Securities (CGS) but sits off the efficient frontier.
By altering the composition of assets, less risk and more return can be achieved to move the portfolio out to the efficient frontier. For example, by investing in lower-grade credit securities (that is, moving from AAA to AA) we are able to reduce the risk of the overall portfolio and increase return. Simply, this means that buying less CGS and more bonds issued by banks than the Index weighting dictates, can provide an active manager with the ability to add value and reduce price volatility. However, it requires the manager to be able to pick securities with a low risk of default and generally stable or tightening credit spreads.
Herd mentality creates investment opportunities
The chase for equity-like returns from fixedincome securities is a classic example of the “herd mentality” where investors follow the crowd and invest in the latest trend or hot tip – based on the simple premise: “If others believe, then it is safe to also believe”. It is one of the many investor behaviours that can lead to the mispricing of securities, providing investment opportunities for active managers and savvy investors.
In the lead-up to the GFC, we recognised credit was over-priced, particularly when spreads between credit and government bonds narrowed from 200 basis points in 2005 to just 30 basis points on average in 2006 (that is, the higherrisk credit securities were only yielding 0.3 per cent more than AAA-rated government bonds). Credit margins had declined to the point where they covered very little of the risks inherent in these securities, particularly those rated BBB and lower. We subsequently avoided many of these securities, focusing more on the high-quality, highly-rated securities and government bonds. We suffered underperformance in the short term as credit continued to run, but over the long term this strategy paid off for our investors, with no securities in the Tyndall bond funds defaulting.
Additionally our flagship fund, the Tyndall Australian Bond Fund, has outperformed its benchmark, the UBS Australian Composite Bond (All Maturities) Index over the five-year period to May 31, 2010, by an average of 0.62 per cent per annum before fees – with less risk than both the Index and median Australian bond fund (Source: Morningstar). Please note past performance is not a guarantee of future performance.
Tips and tricks
Fund managers are not infallible by any means, but there are steps and disciplines they implement to help reduce the influence of investor behaviours on their investment decisions. By far the most important method used by fund managers is the investment process. The process sets in train steps and rules to follow - it enforces a discipline to keep them on track to achieve their targeted risk and return objectives.
At Tyndall, we adopt a multi-layered process comprising research, analysis, sector allocation and stock selection decisions, risk management, execution and review. It’s this last step in the process that is perhaps one of the most important and, if overlooked, can potentially be the biggest investment trap for investors.
Process over outcome
Our team are strong believers in process over outcome. Often investors can fall into the trap of focusing on the outcome rather than their methodology and valuation process. When we receive new information, we don’t focus on the outcome – that is, the impact on the return we are seeking to achieve – but we review the process and how the new information affects our valuations and ultimately positions in particular securities. We believe that by focusing on the valuation and the risks, the returns will look after themselves.
Our team of seven investment professionals meet first thing every weekday morning to review the previous day’s and overnight market movements. We review what’s happened, why it happened and the impact it may have on the assumptions and valuations that underpin our investment strategies.
We also question what’s happened: is it an over-reaction? Often the market can over-react to a new piece of information, such as a US employment number, which can lead to a sharp sell-off in bonds. If you focus on the outcome, you may get caught up in the momentum and sell down your holding.
If, however, you focus on the process, this information and market reaction could actually be a valuation trigger and represent an excellent buying opportunity.
Our focus on process over outcome is the reason we don’t believe in having stop loss positions – it places too much emphasis on the sale price and not enough on the process and true value of a security. Having said that though, stop losses can work for some investors - particularly those who are risk-averse or have short investment horizons.
Expect the une xpected
Another critical component in our process is to expect the unexpected. In our daily meeting we look at various “what if ” scenarios. What if the Reserve Bank of Australia reduces rates earlier than expected? What if Australia’s unemployment rate peaks at 10 per cent and not the forecast 7 per cent? Or what if the European Monetary Union collapses?
In this regard, we reframe our mindset from one of risk aversion to loss aversion. We subject all our positions to what type of loss may ensue if the unexpected happens. By having procedures in place that allow us to price in the impact of “what if ” scenarios, it gives us greater control and a sense of comfort that should the unexpected happen, our portfolios will be better positioned to weather the storm. It also means we are able to take advantage of investment opportunities when they arise.
Don ’t get trapped by “groupthink ”
Fund managers are often criticised for displaying “group-think”, whereby everyone in a team thinks the same and hence their biases are elevated rather than eliminated. This is a challenge for fund managers and is something that we work very hard at managing at Tyndall. The key is having a diverse group of team members on a number of levels including age, sex and personality.
Our fixed income team ranges from an age of 25 up to the early 50s; there are five males and two females; and there are mixed backgrounds and equally mixed personalities and experiences – and to add a little more spice to the equation, we sit in a very small room.
Having such diversity provides greater scope for different views and importantly provides the forum for debate. The biggest challenge here is to ensure that all team members have a voice and are listened to. In many respects I play a devil’s advocate role by challenging views, encouraging alternative views and encouraging the pursuit of a broad range of information sources and contacts in the industry. At times I even ask each team member individually what they think, to ensure everyone has a say or provides input.
We are no doubt experiencing a period of prolonged volatility, and it’s certainly been a wild ride for investors. But it’s important to remember short-term volatility does not equal risk if you have a long-term horizon. Over longer periods of time, volatility can actually present active investors with good investment opportunities. We often see too much focus on the short term, causing panic and large sell-offs during periods of uncertainty. However, these periods often provide excellent investment opportunities for the long-term investor.
The GFC is indeed a perfect example of how investors cannot only be hurt by, but also benefit from, the ever-powerful forces of greed and fear. As highlighted in our previous articles, emotions and behaviours can dictate investor decisions – often poor ones. Adopting a long-term view, remaining disciplined to an investment strategy, and seeking and listening to advice from a professional planner are steps investors can take to reduce the impact of these behaviours, leading to more informed decisions and better investment outcomes.
Outsourcing the investment decisions to a professional manager is another way investors can overcome these behaviours. While they are not completely immune to the behaviours, they have a number of “checks and balances” in place in the form of an investment process which helps them reduce the impact of these behaviours and make more rational and objective investment decisions.