surviving in turbulent
“The flow of
money created by quantitative easing has been artificially suppressing volatility, but this is coming
to an end.”
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Fund data profile
Changing views of asset allocation
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Despite the heightened political uncertainty stemming from shock events such as Brexit and Donald Trump becoming president in the US, for the past couple of years, investors enjoyed a relatively smooth ride when it came to investing in global markets.
Propelled by the effects of quantitative easing and low interest rates, markets seemingly entered an unusual period of calm in 2017. The result was investment success for all those adopting a risk-on attitude in their portfolios, with the risky asset classes performing strongly.
But this was brought to an abrupt end at the start of this year, with markets witnessing a number of short, sharp sell-offs in the face of negative headlines regarding possible trade wars, the unwinding of QE and potential interest rate rises around the world. In short, volatility had once again reared its ugly head and the quandary facing investors is what to do next.
For many investors, returns have been stagnant, with many seeing drops in performance. According to data from FE, since the start of 2018 to 26 October, the IA Volatility Managed, Targeted Absolute Return and Mixed Investment 0 to 35 per cent Shares, 20 to 60 per cent Shares and 40 to 85 per cent Shares sectors have all lost money. Perhaps more worryingly, IBOSS investment director Chris Metcalfe notes within the past few months the range of returns in the Targeted Absolute Return sector, among others, has narrowed considerably.
For example, in 2015, the range of returns between the best and worst performing funds in the Targeted Absolute Return sector was 13 percentage points. In 2016 this fell to 10 points, last year it fell to 8 points and to date in 2018 it has fallen to 5.5 points. He notes that six of the top 10 funds by size in the sector today trade within about 2 per cent of each other.
This, he says, points to the fact that asset allocators are becoming more defensive and more aware of both their peers and benchmarks.“Our approach has been one of caution for some time, especially in 2018, and we see caution in the ascendency within our investments,” Metcalfe says.
“Volatility has been artificially suppressed in the QE period and has been exacerbated by the Yellen era ‘put’, whereby every time there was a market wobble, a central banker – usually from the US but the ECB and the Bank of England also chipped in – would calm down the situation with promises of money printing for longer or lower. In a nutshell, the super accommodative monetary policy status quo would be maintained.”
Metcalfe says clients have become so used to this low level of volatility, that there is now a “substantial” group of advisers and clients who have only known the QE era.
The problem is, with most global central banks committed to ending QE and with interest rates rising across the developed world, these days are coming to an end.
“I think it is sensible to expect that volatility is likely to stay elevated for an extended period now as we move into 2019, particularly as investors try to understand how central banks navigate a post-QE environment and we get through the next downturn,” says AJ Bell Investments head of active portfolios Ryan Hughes.
“This is perfectly normal and it is important to remember that the past few years have been abnormal, rather than volatility itself being abnormal.”
While fixed income has become a much-derided asset class in an environment of falling bond yields and low interest rates, Metcalfe and Hughes both pick out shorter-dated bonds as an area of attraction in this environment.
“In fixed interest we have more clarity with all of our government bond exposure being in short duration bonds to protect against rising interest rates,” says Hughes.
Metcalfe adds: “Our shorter-dated bond holdings helped our fixed income holdings to perform well in 2018 and, in October at least, our gold holdings have been rising when almost all assets were falling.”
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While the market sell-offs in February and October this year have made investors question their attitude to risk, Lowcock argues that it needs to be remembered that volatility and risk are not the same thing. “Volatility is just the movement of share prices, up and down, whereas risk should be linked to the underlying investments, namely, is the company being run profitably and will it deliver on its objectives,” he says. “Aspects such as cashflow, revenue growth and valuation are the long-term drivers of returns and the risks, not the volatility.”
He adds: “Understanding the difference between volatility and risk is one of the biggest challenges for investors and it does not help that their perception of risk changes with the environment.”
For Metcalfe, while volatility is a factor to be considered, it is just one measure of risk. “It will always be the case that the greatest risk is the permanent loss of capital,” he says. “One of the few guidelines you can adhere to as an investor is avoiding markets which are expensive, either relative to the peer group, to their own history or to both.” As a result of this, Metcalfe is currently adopting an underweight position to the US, despite the strength of the market in the last couple of years.“
The sugar high of Trump’s tax cut and the proliferation of share buybacks funded by this and QE’s suppression of borrowing costs will diminish,” he argues. “Strip these out and valuations are expensive on both of the measures mentioned.”
Hughes says that the risk-targeted approach has become embedded into the thinking of many advisers as the correct way of marrying up investors’ risk appetite with investment solutions. But he argues that if markets do become particularly volatile, it is important to remember that the risk levels being targeted are over the long term rather than the short term.“
In very short periods, volatility levels can spike particularly high and the diversification employed by many risk-targeted solutions is not that useful,” he says.“
That said, the multi-asset approach, which aims for steady growth over the cycle, is still a useful method of investing, particularly for those investors who want a solution that matches their risk appetite.”
Versus the high costs of using absolute returns which are currently not delivering on their stated aim, Metcalfe adds that an alternative to holding equities could be US treasuries.
“During an equity sell-off you will get positive returns on US treasuries,” he says. “At the same time these funds cost a lot less than the relative fortune you pay for absolute return funds, where the ongoing charge fees are north of 2 per cent. I accept that it is not their remit to generate positive returns in down markets, but it simply comes back to the question of why are we holding them at all.”
Metcalfe believes that one factor behind the increasingly similar correlation in returns across many sectors comes down to rising concerns around career risk.
“We are seeing managers hunker down more than we ever have,” he says. “Going against momentum is a dangerous thing to do and we have been speaking to UK managers recently who, in the absence of never holding mining stocks before, are now doing so. This is simply because they have been hit hard recently and consequently have become more conscious of the downside risks than they ever have in the past, across all asset classes.”
It is sensible to expect that volatility is likely to stay elevated for an extended period now
Income is another important consideration. Bonds were the mainstay for income portfolios for many years, but this has shifted as yields have fallen.
However, there are still parts of the bond market that pay attractive yields, such as emerging market debt. There is also the possibility that investors will return to the bond market as yields rise.
Lowcock says: “In the past few years of the bond bull market yields were getting incredibly low and in some instances negative, so this pushed income hungry investors into other assets, including equities and infrastructure. A combination of recovering bond yields and expensive valuations in those equities – tagged the bond proxies – has meant investors previously forced to buy shares have taken the opportunity to reverse that position and get the income they need at lower levels of risk.”
The 10-year Treasury yield is at over 2.7 per cent. This puts it ahead of inflation, meaning that investors are receiving a positive real return from government bonds. While UK and eurozone investors are yet to catch up, it is edging in that direction. The bond market may increasingly offer opportunities for income investors.
That said, although there are many reasons to hold bonds, any fixed income allocation in today’s market needs to be carefully managed. The risk profile of bond markets has changed and there are pockets of real danger. At the same time, most advisers do not feel confident enough to allocate between the different types of bonds themselves.
This is likely to be behind the popularity of strategic bond funds. These funds offer
the broadest exposure to the market and allow managers the flexibility to take advantage of changes in bond prices and yields as the markets adjust to an environment of rising rates.
Both Woods-Smith and Lowcock favour this approach. Lowcock likes the MI TwentyFour Dynamic Bond fund, which is run on a team basis, with each team member a specialist in a particular area of fixed income.
Overall, the bond market looks to be a more dangerous place at the start of 2018 than it was at the start of 2017. While there is no catalyst for a sudden sell-off, the slow grind higher of interest rates and inflation will influence returns from here, and is likely to threaten its status as a safe haven.
That said, the bond market is not without its opportunities. Not all bonds are alike, not all are exposed to the interest rate
cycle, and there are still diversification and income advantages. Advisers will have to work with their clients to show the merits of considering an allocation to bonds in today’s climate.
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Understanding the difference between volatility and risk is one of the biggest challenges for investors
With volatility returning, and set to stay for the foreseeable future, should all risk be taken off the table?
For Hughes, within AJ Bell’s Active Managed Portfolio Service, it is not the case of being totally risk-off. Instead, his preference is to be well-diversified across markets and styles, therefore having exposure to growth, value and quality companies across the globe.
“While we see the market as a late cycle, there certainly could be further to run on some growth stocks and therefore we do not want to shut off this opportunity set completely,” he says. “At the same time, some value names have been significantly sold off and look attractive, while quality, defensive companies give us a cushion when volatility spikes.”
Willis Owen head of personal investing Adrian Lowcock argues the biggest challenge for being either risk-on or risk-off is getting your timing right, a skill he describes as being “incredibly hard”.
“Once you get your timing wrong, even just once, you can end up chasing the cycle and always lagging behind. At the same time, trying to trade risk-off and risk-on in markets means increased trading costs and the introduction for the possibility or opportunity to make a mistake.
“Therefore it is better to adopt a long-term approach and look through times of volatility, while having some protection already built into portfolios.”
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