14th April 2015
Cautious investors could be taking much more risk than they think by investing in supposedly cautious multi-asset funds as most of the diversified assets they invest in are exposed to similar inflation and interest rate risks.
The warning comes from multi-asset investor and noted contrarian Psigma’s chief investment officer Tom Becket. The firm has set out to avoid such pitfalls by seeking assets that are not correlated to interest rate risk. Becket also believes that investors should also avoid “really big, really illiquid, extremely unnimble, traditional corporate bond funds” in these circumstances too writes John Lappin.
He says: “Caution is very much in vogue with investors. Everyone wants to invest cautiously but the most confusing thing is that most assets out there are highly correlated. Most are starting to move in tandem. Bond yields have come down further because people have pushed out their expectations for interest rate hikes. We expect a US rate hike in September and in the UK a hike probably at the start of next year.”
The firm’s central view is that in three years’ time interest rates, inflation and bond yields may be around 2.5%. “If we get to that, then cautious portfolios are going to be uninspiring. But the greater danger is that people lose faith in central bankers and inflation picks up more aggressively. If interest rates need to go up further and faster, we think it would lead to significant losses in traditional fixed interest investments and all investments linked to government bond yields”.
He says the three big risks for cautious investors are losing money short term, not achieving growth medium term and failing to keep pace with inflation in the long term and currently they could be exposed to all three.
“Cautious investors need to think about risk totally differently. In the past, market theory would tell you that you hedged your equity holdings by holding positions in long dated government bonds. We think the inverse may well be correct. Your biggest risk for equities particularly high quality equities in sectors like real estate investment trusts, utilities and consumer staples are from a rise in bond yields, so government bonds rather than being a hedge could be the biggest risk to your portfolio.”
“Correlations across asset classes are now incredibly high, we expect them to be incredibly high for the next five years. We are trying to find assets across global sectors that are uncorrelated to bond yields. People need to use innovation. Investors also need to really work out quite what the risks are of being in some of these really big, really illiquid, extremely unnimble, traditional corporate bond funds. We think people need to think about things from a thematic perspective rather than an asset perspective”.
Distortion of markets means many supposedly different assets are the ‘same trade’
He says that a typical cautious portfolio has a little bit in cash, quite a lot in sovereign debt, quite a lot of investment grade credit, developed world equity – mostly in income type strategies – a lot property and alternatives such as infrastructure loans, real estate investment trusts. “With the exception of cash, it is all correlated to what happens to government bond yields. If government bond yields start going up and prices going down this could put your cautious portfolio in a very difficult position from an absolute and particularly real return perspective in the next five years. If we go into an interest hike cycle, these sorts of investments could easily lose money and cautious investors may not understand why”.
“We believe that the only solution for cautious investors is a mixture of diversification and innovation. Diversification is not simply throwing together a range of different asset classes, rather correlations have to be broken down and all manner of investments searched through. This point is particularly important at this time, as the distortion of financial markets by the central bankers has meant that many investments from different asset classes are now all effectively the ‘same trade’.
Liquidity warning on giant bond funds
In terms of mutual corporate bond funds, Becket says the problem is you are constantly in a ‘irredeemable type structure’. “You can buy a bond like a 10 year UK Treasury and work out if that is good value. In a bond fund, they are constantly redeeming bonds and duration is being constantly pushed out, so really investors don’t know what they are going to get. He says: “Some of these funds have grown to £25bn in size, and having credit specific dynamics is much harder, targeting companies and themes is much more difficult. You can’t be credit specific and also you have no control over duration because you keep pushing it out further. For us, we think mutual bond funds are really quite dangerous. We think, you as an investor you don’t know what you are going to get from that fund.”
He adds:“Central bankers might have saved the world from economic depression but we worry that markets have borrowed much of the future’s returns. Prices of some assets, particularly in fixed interest markets have totally detached from medium term fundamentals. Investors have been forced out of cash and been driven ‘along the risk curve’. Any change to interest rates, the trajectory of economic growth or a return of inflationary pulses could see a major inflection point in the fortunes of the assets that have done so well in the last few years.
Psigma’s MPS Cautious portfolio is currently made up of over 11 core asset classes across five thematic sub-sectors:
· Long Term Equity with value most likely to be found in the disliked cyclical and recovery areas of the markets
· Emerging Market Growth giving exposure to the growth engines of the world
· The Hunt for Yield where we have moved the vast majority of our bond money from mutual funds to segregated mandates and allocated a small amount to EMD, where yields on offer are far higher than in the insanely expensive developed world
· Inflation Protection which is best found by sticking with resource allocations
· Defence where we source uncorrelated returns in highly correlated markets to ensure we deliver positive returns regardless of market direction.