Written By: Terry Purcell
Terry Purcell of Permal Investment Management says that in the current transitory stage of the investment cycle, portfolio diversification is as important as it has ever been
The global investment cycle has matured. We are in a world of low interest rates and tepid global growth, set against a backdrop of overly rich credit and toppy equity markets. Such an environment has created a paradox: richly valued markets and slow prospects, together not great bedfellows. There are very real concerns that include the continued slowdown in China, ill-managed or at least poorly communicated US interest-rate hikes, and geopolitical threats reaching a 25-year high. The tide between reward and risk is turning. Preparing investment portfolios for this transitionary stage to protect against potential downside risks, as well as take advantage of arising opportunities, should therefore be a key focus for 2016.
The general consensus is that the end is nigh for the 35-year bull market in rates and six-year bull market in credit. Following seven years of accommodative monetary policy, reducing rates to near zero levels, the US raised interest rates in December 2015. US tightening now commences. Going forward, the probability is that conventional bond allocations are unlikely to provide the return profile experienced over the last few years. More traditional credit markets could also struggle with a potential asymmetric return profile to the downside. The mid-1990s provided an example of the negative impact of a 2% rate rise, when bondholder drawdowns reached 10%.¹ Credit selection will therefore be paramount.
The flood of easy money, in the form of quantitative easing (QE), has inflated risk assets such as equities. While there is divergence between government policies, with the US and UK more focused on the path towards and timing of tightening, while Europe and Japan keeping the monetary flood gates open, overall valuations remain near all-time highs. Is this sustainable and for how long? During 2015 companies continued to reduce their equity base through buy-backs subsidised by cheap debt, in many cases veiling falling earnings growth and contracting company profit margins. As a result markets appear expensive with the current cyclically-adjusted price earnings (CAPE)² ratio standing at 25, which is considerably higher than the long-term average of 17. The future likely returns given current CAPE would indicate a real annualised return of -1.7%³ over the next five years. The early days of monetary policy, when risk assets benefited, are over with the end of QE and start of the tightening phase in the US. With this, performance gains based predominately on equity beta are likely to be far harder to come by, with active management returning to the fore.
2015 witnessed an increase in volatility and whilst not at worrying levels, it could be seen to be a precursor. Given the current environment – including early January’s turbulence, volatility in traditional asset classes looks set to continue in 2016. There is no doubt that volatility can prove painful, but pension funds might also be able to take advantage in such an environment.
Portfolio diversification is as important today as it was over 60 years ago when Markowitz set out his case for building a portfolio of investments based on their relative correlation to other assets, and becomes more significant the further along the investment cycle we tread. Fixed income has consistently had little correlation with equity markets, which makes it a good diversifying asset class. This relationship is key to asset allocation decisions and most investors continue to follow this thinking. However, we are experiencing a new paradigm, one that has been generated through central banking policies following the credit crisis in which this historical asset class correlation relationship is changing, eroding the benefits of diversification. In recent periods of market concern, we have seen correlations turn positive, ultimately exaggerating drawdowns in overall portfolios.
It is difficult to predict the future relationships of these traditional asset classes, but with the average LGPS allocation to equities being 52% and to fixed income 16%, with a typical funding level of 80%⁴, it could be prudent to investigate allocations that might possess more robust diversification benefits. A prime example is hedge funds.
Can hedge funds provide an alternative option for a DB pension fund? We believe that they can. Firstly it is important to remember that hedge funds are not an asset class; they span asset classes and by design have inherent flexibility to take advantage of investment opportunities that traditional funds cannot. Hedge funds can help to balance the risk/return profile of the overall DB pension scheme as various hedge fund strategies can be allocated at different stages of the investment cycles and serve a number of purposes: as growth investment, liability matching or pure diversifying allocation.
There are pockets of opportunities that certain hedge fund strategies can take advantage of in this investment cycle transition period. This is especially true for investment styles that can benefit from increased volatility and dispersion amongst and within asset classes. In such an environment, the typical strategies we would favour are:
Notwithstanding the recent volatility, global equities have had a strong run and now trade near all-time highs. Whilst there remains some upside potential for the directional trade, P/E multiples across regions remain near historic peaks, increasing the risk of a pure directional beta allocation. Fundamentals are beginning to influence share prices again, and we anticipate the dispersion between winning and losing companies to widen further, providing a good playing field for long/short managers with lower net market exposure. Managers skilled in fundamental analysis and possessing a proven track record of providing alpha from their short investments in specific stocks are likely to weather the turbulence and benefit from this transitionary phase. Furthermore, recent sentiment-driven volatility provides good opportunity (both long and short) for specialists in sectors such as technology, healthcare and energy, and managers with a European and Japanese focus.
2015 was the biggest M&A year in history and corporate activity is set to continue into 2016 as slow nominal GDP growth makes it tempting for companies to grow via acquisition. Many companies remain overcapitalised with large cash hordes while interest rates remain low and debt financing is available on favourable terms. More recently, widening deal spreads have begun providing further upside potential. Given the market backdrop where directional exposure is less favourable, merger arbitrage specialists (managers that simultaneously buy the shares of the acquired company and sell the stock of the acquirer) are able to provide a more rewarding risk/return profile. These specialists focus on company fundamentals to assess the probability of a deal closing and typically have lower net exposure, as well as tending to trade differently from both equities and fixed income securities, providing important diversification characteristics.
The global macro strategy has had a testing period over the last few years. The strategy seeks to identify changes in global economies, brought about by government policies and in turn impacting financial instruments that managers look to exploit. Since the credit crisis, it hasn’t been that simple as the impact of these government policies and flood of QE monies changed market dynamics. This led to outcomes either not expected by the market or with limited life span, causing whipsawing market reaction without any clear trends.
Yet this is changing. Policy divergence now being witnessed is creating trends and macroeconomic dislocations across asset classes. Discretionary and systematic macro funds typically have broad global mandates and are well placed to access such opportunities across and within asset classes. These strategies benefit from increased volatility and exhibit low to negative correlations to traditional markets during times of stress, like those we have been starting to see in late 2015 and early 2016. Investors certainly benefited in 2008 when the average macro hedge fund had positive returns. These managers are likely to provide the characteristics required to increase an overall pension plan’s risk/return profile during times of market stress and the increased volatility that we expect over the next two years.
Long/short credit is not a strategy that works well in all market environments. An ideal backdrop is one that has return dispersion among sectors and individual names, characteristics we are witnessing today as the monetary taps are switched off and uncertainty enters the market. In addition to sector return dispersion, the current environment offers individual security return dispersion. As correlations among securities of single companies decline, good credit analysis can be rewarded with profits on both the long and short sides. Shorting credit is a skillset not all possess but which will become ever more important. During such periods, managers that can identify favourable and unfavourable trends, in a true long and short fashion, and those that can trade nimbly amidst restrained corporate credit liquidity are favoured.
Whilst not quite there yet, we believe that a new credit default cycle is around the corner, with defaults looking set to pick up significantly during 2016. This is partly because of the level of high yield issuance, with energy a key sector for potential defaults. This is due to expiring commodity hedges in 2016 and 2017, the decline in energy prices, restructured company credit lines and tighter capital markets. We also believe defaults may extend beyond the commodity complex given recent high yield market weakness. According to JP Morgan Credit Research, 34% of the US corporate bond market, or $437 billion, is already trading at stressed or distressed levels (defined as 90% of par or lower). This will represent a massive opportunity for skilled distressed managers.
A differentiated source of return Alternative investments do provide a differentiated source of return that is not derived solely from market risk or dependent on market direction. This is important, but they are also well suited to the transitionary stage of the investment cycle that we find ourselves in. Consequently, on a standalone basis such investments can provide reduced correlation characteristics in a variety of ways across asset class allocations, while at the overall pension fund level they can diversify traditional risk, helping to smooth returns and reduce overall volatility.
1. Moody’s Seasoned Aaa Corporate Bond Yield (Jan. 1919 – June 2012
2. The S&P 500 divided by a 10-year average of trailing reported earnings
3. BCA Research