Defensive is no longer defensive, good news is no longer good news, up is not up, down is no longer down; such are the twists and turns introduced into global financial markets by more than a decade of unprecedented monetary policy and central bank actions. Once simple conversations with clients relating to the risks and returns of their portfolios are now dripping with complexity.
Further, risk factors, including the escalation of trade wars or even all out nuclear wars continue to keep investors up at night, particularly those investors who remember the global financial crisis like it was yesterday.
And yet, the world’s major developed equity markets continue to deliver strong double-digit returns, the result of which has been a of FOMO (fear of missing out) felt by investors holding onto defensive strategies, some of whom are sitting in cash producing ever-dwindling returns.
“At the core of it everyone is trying to achieve the Holy Grail at the moment which is to try and maintain an investment portfolio that continues to deliver what is required by clients without extending risk too much at the same time,” Dr Ben McCaw, MLC Investment Management’s portfolio manager and head of capital market research (pictured), said.
“The main challenge is that the future world we’re facing into is quite complex and very risky, but that is contrasting with the return profile where investment strategies have been exposed to great asset price increases we’ve experienced over the period of time which people have condition themselves to,” he said.
McCaw joined portfolio construction and asset class experts, along with sector specialist investment experts and front-line financial advisers to discuss challenges associated with navigating and explaining investment risk and investment outcomes in the current environment.
“We’ve seen a 20 per cent increase in some [equity] markets over the last six months and we’re trying to talk to clients about long-term returns and having the right conservative approach, a balanced approach. But then the mark return comes into it,” Cameron McAusland, a director and adviser within his own practice part of the MLC Advice network based in Randwick in Sydney’s inner east, said.
“It becomes even more of a challenge explaining this because we’re arguing or competing against industry funds, retail funds, getting our own asset allocation right, defining what is defensive and what’s growth,” McAusland described.
The July round table discussion is the second in a series following on from last year’s discussion entitled Investment Risk: Caught between perception and reality.
“Twelve months ago we sat here wondering what the event catalyst was going to be to create a GFC style event. Because I remember the GFC, it was horrendous. Seeing people effectively losing 20 per cent and 30 per cent, these people were keeping us up at night and everyone around the table he was affected by this. And now 12 months we still don’t know if it’s coming but we are still managing these expectations,” McAusland described.
“It’s the dichotomy or the disconnect with and risk and return is what is occupying our minds as we sit here today,” McCaw noted, who added it is the hardest environment that he’s seen in his whole career to invest money.
What is defensive and how investors should be thinking about traditional portfolio construction strategies is difficult to answer and important to consider for investors in the current environment, John Woods, MLC’s co-portfolio manager, said.
“One of the things we talk about a lot is that it’s one thing to be defensive, but it’s how you become defensive that is ultimately going to determine whether you can keep up with the other strategies such as equities or some of the growth returns,” Woods described.
“So there seems to be a tendency for people at this time of the cycle to just to sweep all their defensiveness into cash, which is very expensive as we know [from a returns perspective] this is especially true if you consider the fact that if you’re comparing it with equity markets, you’re probably giving up on average 6 per cent or 7 per cent a year,” he said.
There are some strategies in fixed income that are compelling despite bond yields hitting all-time lows in Australia and across Europe, Woods noted. Woods also pointed to some private market opportunities and strategies such as ‘put options‘ within the local bank segment that could offer investors respite from risk while also maintaining a reasonable return profile.
“The problem in this market also is that becoming defensive can be extremely expensive, especially over multiple year periods,” he described.
He added that characteristics of assets traditionally defined as defensive can change depending how they’re managed.
“We saw this with the infrastructure stocks going through the GFC, their cash flows aren’t as defensive as perhaps they were made out to be.
“There is no doubt that a toll road’s cash flows are relatively defensive, but that doesn’t mean the current toll roads available to investors are operated away that the end investor gets that defensive exposure,” Woods continued.
Woods explained that in order to find genuinely defensive assets in this environment, it means separating good investors from not so good investors, which ultimately comes down to the underlying manager’s ability to really “knuckle down” and address risks associated with this environment where asset prices are rising against the grain of economic growth.
The challenges associated with seeking out genuinely defensive options has thrown the traditional portfolio construction approach into doubt, according to Veronica Klaus, Lonsec’s head of investment consulting.
Bonds remain a fundamental building block but their return profile has changed in the current environment, Klaus pointed out.
“There’s a number of different reasons why bonds are in investors’ portfolios, whether it be for income or diversification but also so that part of the portfolio that doesn’t go down, it’s very defensive… given where bond yields are now the question is where do you go? We know the risks but how you position for those risks I’m not able to come up with a solution,” she said.
“If you’re building a portfolio and with a primary objective to play that defensive role, anything that’s listed can be exposed to capital volatility, which makes it a difficult story to explain to the end client or the mum and dad investor because they don’t want to see a negative or below market return,” Klaus highlighted, while emphasising the challenges associated with applying traditional portfolio construction principles in the current environment and expecting to tick both the risk and return box.
The bond-proxy conundrum
Australian investors have their own unique challenges navigating risks, particularly given the concentration of bank and resource stocks on the local exchange, well known banking analyst Brian Johnson, pointed out.
“Most people think banks are a bond proxy, but they’re not. They are the opposite actually,” Johnson said. He added that Real Estate Investment Trusts are a more comparable bond proxy but with their own unique characteristics on a count of their debt.
“I have a look where five and three bond rates were in the last couple months, it means every six months there’s a 1 per cent reduction in a bank’s earnings power, and that just becomes relentless for five years if bond rates stay where they are,” Johnson noted.
Investors are taking a risk investing in bank stocks for the yield if they’re not facing up to the realisation that the Australian banks face “massive” forward earnings growth hurdles to sustain their significant dividend yields, he said.
Meanwhile, Johnson also described a trend in which the move of investors from actively managed funds to passive strategies is exacerbating the share market risk associated with banks.
“When we see money leaking out of active management going to passive, that by definition is going from a structure that’s underweight banks into something that’s neutral in banks so it’s incremental buying,” Johnson describes, a phenomenon he said he believed is exacerbating the “squeeze up” on those stocks which feature heavily in the benchmark.
Many Australians will be exposed to this sector given around half of the share registers of the big four institutions are made up of retail investors, he stated.
There is no doubt the bond-proxy or perceived bond proxy investments are driving significant returns in the market, Ken Hyman, an investment manager with Antares Fixed income, he added.
Despite the risks he says there are also some “extractable returns” in certain segments of the market where fundamentals are good including in the commercial and in particular in the industrial and logistics segments.
“Where some of those returns are transferable are in a couple of the direct commercial property REITs that have a weighted average life of over 10 years or more. If you track their past performance, say, the last 12 or 18 months, it’s actually tracking the 10 and 20 year bond yield very closely – this is actually accounting for 70 per cent or 80 per cent of the return.
However, Hyman also pointed out that when bonds sell off by, say, five or six basis points, the REIT sector will sell off 2 per cent or 3 per cent on the day.
“To me investors really need to get a handle on that [volatility] to invest in this sector,” he said.
Apples with apples
Stuart McDonald, a principle with NAB Financial Planning in Chatswood in Sydney, said he will try to stick to the client relationship and leaves the investing up to a multimanager in this challenging environment.
“I see myself as more the counsellor dealing with the mums and dads, that type of thing. We have some clients who want to have the conversation about where risks in the market are but what they’re often most interested in is the end result and if I’m saying they can get a 6 per cent or a 7 per cent return and they see an industry fund spruiking an 8 per cent to a 10 per cent then they want to know the what and the why,” McDonald said.
With performance comparisons front of mind among investors in light of renewed industry fund advertising, advisers are increasingly finding themselves discussing attributes of assets, categorisations and the role liquidity plays in returns, both McDonald and McAusland, agreed.
“I think everyone gets a little bit tied in a knot when we’re talking about defensive versus growth type assets,” McCaw noted. He highlighted that what’s often more important is the investors’ appreciation of how an underlying asset might behave in certain scenarios.
“Ultimately what our clients are interested in, at the end of the day, is the reliability or the robustness of an asset. If an asset’s return is more reliable then it’s defensive, but if an asset’s return is more variable and subject to more extreme outcomes,” he said.
“The problem ends up being there can be limits to transparency that you need in order to get an answer to that question,” he added.
“I think this particularly relates to the alternative sector – if you’ve taken on an alternative’s portfolio risk you want to understand how robust the asset is and how it performs,” he said.
Clear and present risks
Investment risk is on investors’ minds today more than ever before, the participants of the discussion all agreed.
This is the first time in a long time when geopolitics is having a very direct influence on financial markets and how portfolios are constructed, Lonsec’s Klaus reckoned.
“Geopolitics is adding another very significant layer of risk to what is going on,” she said.
“What we’re seeing is example after example of reactions in markets and financial markets that even with the benefit of hindsight are hard to explain,” MLC’s Woods said.
“If you go back and have a look at the second half of calendar year 2018, bad was bad. And what you can see now, suddenly bad is good,” Johnson said, pointing to the trading of bank stocks leading into and following the announcement of the Federal Election result in June.
“I don’t believe in many cases local markets are actually being driven by value anymore, they’re driven by momentum and basically valuation signals. So basically, that creates a feedback loop,” he said; he specifically pointed to the trading of bank stocks.
What is not wise, Woods concluded, is for investors to convince themselves that real interest rates are unnecessarily low.
“We often hear people talk about artificially low interest rates, I’m not really sure that that’s true,” he said. Rates are low because debt is high and also because much of the world economies have productivity issues, he added.
“So there’s this whole series of risks in the market which are also the risks that support the level of real interest rates. However just recognising this in its own right doesn’t make it any easier to manage,” Woods said.
This report is based on a Professional Planner Round table, sponsored by MLC