As volatility returns, and looks like it’s here to stay, portfolio managers are casting around for ways to control risk and eke out gains, while still bracing for a slump in global growth.
“Badly behaved markets can ruin peoples’ retirements if they are exposed to too much risk and do not have the capacity to recover from large drawdowns,” says Susan Gosling, head of investments at MLC.
“But the complexity of the investment world makes it difficult to take an objective view of the future. There is a behavioural tendency to overreact to repeated good news which leaves investors unprepared when things turn out less positively.”
With very low interest rates and an enthusiastic quantitative easing program over the last 10 years, investors relying on interest income missed out and so many conservative investors were pushed up the risk spectrum. This weight of money has meant that many assets have become expensive in a widespread hunt for adequate returns. While this process can’t go on forever, the bias is to extrapolate continuing strong returns.
The tipping point
Gosling reminds us that at some point, as rates rise, there is a tipping point at which investors will start coming down the risk spectrum. She sees this as one of many risks to over optimistic (and overconfident) market expectations which reflect the past more than the future.
“However, the long period of mostly positive news – with limited interruptions – has encouraged investors to extrapolate strong returns and neglect consideration of risk. We suspect that many investors remain overly optimistic and vulnerable to some misperceptions or under appreciation of risk,” Gosling says.
“And with assets generally expensive, there is a real challenge from the lack of diversifiers that portfolio managers can turn to seek returns while limiting risk,” she says.
Martin Watson, managing director of Perth-based advice practice, Bellwether Financial Group, agrees there is a lot of global uncertainty around Brexit and US and China trade negotiations, not to mention the Australian apprehension around the upcoming election.
“These remain very attractive when compared to fixed interest or cash returns,” he says.
“My mantra is, there is always opportunity in any market and staying calm in the face of noise always
delivers sound long term results.”
Check your bias
There is a common tendency for people to perceive events that have already happened as having been more predictable than they were before they happened.
“Thinking that whatever happened in the past was inevitable is really common,” she says. “The truth is, there are always a number of different things that could have happened, so thinking through as many possibilities as you can will help you prepare your investments.”
There are many possible futures that could play out – which will occur is not predetermined and therefore not reliably forecastable. Gosling suggests that this is a reality which the industry does not pay sufficient attention to.
“An important reason for this lies in those innate psychological biases that all are prone to. Very important among these is a tendency to assume that the future will look like the past.”
“The future is always uncertain, and today we have a particularly challenging environment.”
There is uncertainty, for example, around the future course of monetary policy, the consequences of social discontent and the rise of more militant labour forces; and there are risks that trade and other policies are misdirected. The future decisions of policy makers, notably US President Donald Trump, are also unusually uncertain, as is the ultimate course taken by the UK with respect to Brexit.
Another bias is to remain particularly grounded in the experience. This is called emotional reasoning.
“When thinking about the future it can be very hard to imagine a world that is significantly different from today,” Gosling says. “So it is important to consider the ways in which the future could play out. By considering a comprehensive set of distinctive potential future outcomes or scenarios we can build an understanding of the future sources of risk and opportunity.”
Position for volatility
When it comes to retirement investing, Watson builds out environment.
“I often talk to clients about no longer having to work, as opposed to retiring,” he says. “And with the smart use of investments and savings, the day you no longer have to work does not need to be 60 or 65 or 67 or some other age set nominally by a government or an employer, but rather a date that you choose.”
That said, when volatility erupts, Watson spends a lot of time educating clients around core ideas that allow them to withstand market gyrations and minimise disruption to their income streams.
“We also ‘tweak’ portfolios at that time to again minimise the impact of volatility of income,” he says. “We tell our clients we can’t eliminate volatility of capital but being aware of the difference between the two and that despite what we were taught at school, a temporary reduction in capital does not mean a temporary reduction in income.”
Outside the box diversification
Portfolio managers are working hard to generate returns above inflation, but need to appropriately limit the risk exposure.
“Outcome-based real return funds such as MLC Inflation Plus, are seeking returns above the inflation rate while limiting the exposure to negative returns in difficult investment environments. In seeking inflation plus returns, we can be less concerned with returns versus market indices, and this frees us to invest only in those companies that offer an adequate reward for risk,” Gosling says.
Traditionally, bonds have been a wonderful diversifier of equity risk. But as the effects of extraordinary monetary policy still reverberate around bond markets, managers have instead sought new ways of portfolio construction.
Gosling points to using foreign currency as a useful diversifying tool for the MLC Inflation Plus funds.
Given Australia is an open economy and is geared towards global growth, when things are going well the world over and for equity markets, the Australian dollar tends to be strong.
But conversely, in a weak environment, the Australian dollar is weak.
“That is really valuable for us,” Gosling says. “Yes, the currency exposure provides an offset to equity market risk and we’ve used that effectively over the recent years.”
Also, because the funds are decoupled from a benchmark, managers have much more freedom in finding new opportunities that bolster the fund towards its objective of achieving real returns for clients.
Concerns about vulnerabilities in the Australian economy, thanks to high levels of household debt, an extended residential property market and a reliance on offshore funding, lead the team to seek new ways to control that potential downside risk.
“Recently, we used derivatives strategies to limit downside exposure for example in the banking sector, and at other times we’ve had no exposure to the domestic banks at all when risks were very elevated”.
“What we try to always do is combine that macro viewpoint with a bottom up approach to individual companies that provide us with an extra level of resilience,” Gosling explains.