Prolonged QE lulled markets into a false sense of stability

The recovery from the Global Financial Crisis (GFC) has been largely assisted by ultra-loose monetary policy and unprecedented levels of Quantitative Easing (QE), which has been highly supportive of global equity markets. QE provides additional liquidity within the financial system via a central bank purchasing securities in efforts to increase the money supply and encourage lending and investment. Following the GFC, a number of central banks adopted this unconventional monetary policy in attempts to spur economic growth, despite the long-term efficacy of this experiment remaining unclear. However, prolonged bouts of QE depress interest rates to an abnormally low level, and as such capital is shifted into higher-yielding financial assets. This change in investor behavior consequently distorts capital markets by artificially inflating the value of financial assets while decreasing volatility.

As the Chart 1 below shows, central bank balance sheets were relatively static until ‘QE1’ was initiated. The years that followed involved significant central bank market intervention which has resulted in periods of unusually depressed volatility. This is outlined in Chart 2, which illustrates the uncharacteristically subdued dispersion of returns during the GFC recovery, which is attributable to the excessively accommodative monetary policy adopted during this period. Conversely, in the pre-GFC period, it is believed that market euphoria contributed to atypically low dispersion of returns.

Chart 1: Global central bank balance sheets, 2006-18

Source: AQR, Bloomberg

Under normal market conditions, the appeal of Alternative strategies within a well-diversified portfolio relates to their ability to dampen volatility and enhance risk-adjusted returns when blended with other asset classes. Unfortunately for investors in this asset class, prolonged quantitative easing has largely stifled volatility and asset class dispersion of returns which hedge funds have attributed to their ongoing underperformance. As such, protracted periods of loose monetary policy across the last decade has heightened correlation and lowered the dispersion of returns amongst asset classes and the underlying securities which has seen Alternative strategies become a less attractive value proposition to investors.

Chart 2: Historical dispersion of returns

Source: AQR, Bloomberg

However, in 2018 inflation finally reached the 2% p.a. target after years of chronically undershooting the US Fed’s target band of 2–3%. The combination of robust economic growth and an uptick in inflation emboldened the Fed’s hawkish stance and led to four interest rate hikes last year. Consequently, the process for central banks to unwind their inflated balance sheets and normalize monetary policy to counter runaway inflation is Quantitative Tightening (QT). Similar to QE, QT remains largely untested as it involves draining liquidity from the financial system, which is broadly negative for financial assets. The market volatility observed throughout 2018 was largely attributable to the regime change from QE to QT, which saw an increase in risk premia manifest into deteriorating P/E multiples and equities derating significantly. Similarly, the initiation of QT resulted in poor returns for fixed income securities due to bond yields spiking and credit spreads widening. Overall, the elevated levels of volatility throughout 2018 culminated in disappointing returns across traditional assets class.

Geopolitical factors are creating a powder keg environment

The abrupt market dislocation which followed the brief tightening phase in 2018 has resulted in global central banks abandoning any prospect of a return to normalized monetary policy. Most notably was the dovish ‘Powell-Put’ which sidelined the Fed governor’s previously hawkish rhetoric, replacing it with a more accommodative monetary policy stance which has been replicated by central banks globally. This about-face from Powell in conjunction with additional easing and fiscal stimulus in China led to a significant reversal and market rally for the remainder of the 2019 financial year.

Trump’s adversarial negotiating techniques continue to weigh on markets with pressure mounting for a permanent truce as the 2020 election looms, the Chinese economy reports the slowest economic growth in decades, and the German economy teeters on the brink of recession. Trump’s modus operandi has typically been to threaten international trading partners with economic penalties for not kowtowing to his demands, and this approach has been mostly successful, with the exception of China. However, there is a limit to the resilience of the US economy as the sugar hit from Trump’s hallmark tax cuts fade. Consequently, the US Fed was forced to cut interest rates by 0.25% in July for the first time in 11-years, citing the trade wars and a global economic slowdown. Meanwhile, markets continue to grapple with the increasingly hostile US-Iran relationship, the perilous Italian sovereign debt challenge, and the North Korean nuclear program.

The US-China trade war re-escalation in early August quickly dispelled any hopes of a prolonged market recovery in 2019, with Trump abruptly announcing further tariffs on virtually all remaining Chinese imports. The US Treasury department subsequently labelled China as a ‘currency manipulator’ after the country allowed the Yuan to breach the psychologically critical level of US$1/¥7, resulting in additional tit-for-tat countermeasures by both sides. As such, August was a tumultuous month for markets with severe selloffs followed by relief-rallies, new tariffs precipitating reversals and bravado foreshadowing olive branches. Trump’s public rhetoric continues to be equally volatile, oscillating from heaping praise on the ‘strongman Xi Jinping’ to declaring him as America’s greatest enemy, with the unpredictability of such events (i.e. Tweets) whipsawing markets.

Trump’s public optimism has never faltered, despite his economic credibility starting to weaken in the face of a synchronized global slowdown and fears of an imminent recession. This was highlighted when the yields on the 10-year and 2-year Treasury notes inverted in August for the first time since the GFC, which historically has been a precursor to every recession in the last 50 years (albeit the timing is notoriously unreliable). However, critics will argue that protracted periods of QE have distorted the yield curve such that its predictive qualities are now weak or non-existent. Despite this, it does clearly indicate that investors are preparing for a global slowdown, which again sparked a savage wave of panic selling and a thirst for safe-haven assets.

The global economic outlook continues to deteriorate with Brexit uncertainties similarly contributing to the powerful recessionary forces that are gathering pace. The UK prime minister Boris Johnson has steadfastly committed to leaving the European Union on 31 October. Johnson’s unwavering commitment to Brexit highlights the increased probability of a ‘no deal’ Brexit, which has further exacerbated the pessimistic outlook held by markets. The potential for a disorderly Brexit has thrust the pound into a downward trajectory while simultaneously crimping corporate sector activity, leaving the economy hinging on a recession. As Chart 3 shows, this heightened uncertainty and volatility has led to significant underperformance of the FTSE 100 Index versus the MSCI AC World Index since the Brexit referendum was held.

Chart 3: MSCI AC World Index vs FTSE 100 Index

Source: Lonsec

How Alternatives can help mitigate the effects of volatility

The ongoing trade dispute, diverging monetary policy, populism, Brexit uncertainties and concerns over the longest economic expansion on record running out of steam have all culminated into the elevated levels of volatility observed throughout 2018-19. However, this potentially paves the way for Alternative strategies to deliver alpha to patient investors. Increased volatility and dispersion of returns amongst asset classes may support Alternative assets, as risks within global financial markets remain tilted to the downside amid a synchronised global slowdown. That said, Alternative strategies failed to protect and generate alpha during the 2018 correction where the environment was more conducive to performance.

This historical relationship is best illustrated through contrasting the below two charts. Chart 4 highlights the historically positive correlation between volatility and Alternative assets. This is captured via a composite of the excess returns (bank bill rate plus 3%) generated among Lonsec’s Alternative asset peer group against the VIX, which is a measure of implied volatility. The results generally illustrate a stronger correlation during periods of heightened volatility, and therefore, greater excess returns for Alternative strategies when markets are distressed. Conversely, Chart 5 elucidates the typically negative correlation between volatility and broader equity market returns.

Chart 4: Post-GFC volatility positively correlated with Alternative assets excess returns

Source: Lonsec

In an increasingly volatile and late-cycle environment, Lonsec remains overweight Alternative assets in efforts to leverage the more prominent market dislocations occurring. Despite their generally tepid returns in a strong bull market, Lonsec emphasises the importance of Alternative investment strategies in client portfolios, as skewed valuations create an attractive opportunity set for contrarian investors. Alternative strategies may provide a degree of insulation from market turbulence through their broad-based diversification via uncorrelated and unconventional investment strategies.

Chart 5: Volatility and S&P 500 Returns Offer a Negative Correlation

Source: Lonsec

While the current economic expansion may continue beyond the consensus expectations, Lonsec highlights the importance of including uncorrelated and diversified return drivers into balanced portfolios. In this respect, Alternative strategies continue to offer a compelling late-cycle solution in the face of a sustained bull-market, a gradual economic softening, or a severe equity market deterioration.

Many retirees struggle to have enough income to fund a comfortable retirement because of an over-reliance on so-called “low risk” asset allocations, a problem that requires innovative solutions to overcome according to the team at Legg Mason’s Martin Currie.

Access the full article here.


Bonds have been unrelenting in 2019, rising in stark defiance of investors who called a fade to the rally in late 2018, when the US Fed appeared determined to hike rates. This insatiable appetite for bonds has seen yields plummet to record lows in several markets, while the quantum of negative-yielding debt is climbing ever higher.

As the chart below shows, the market value of bonds tracked by the Bloomberg Barclays Global Aggregate Index has risen to nearly US $14 trillion and pushed above its 2016 peak. Negative-yielding bonds now make up around one quarter of the index. European safe-havens like Germany and France make up the lion’s share (if you can call it that), with more than 80% of Germany’s federal and regional government bonds in the red.

The value of negative yielding bonds has rocketed in 2019

Source: Bloomberg

Market fears of a faltering US economy are becoming more evident with the Fed taking out some insurance with a 25 basis-point cut to the funds rate at the end of July. The question is will there be another? The yield on 10-year US Treasury bonds has fallen from 3.24% in November 2018 to 1.71% in early August, amounting to an almost 40% rise in the value of long-duration Treasury bonds. The bond market continues to track a deterioration in global growth but so far there are few signs that more aggressive action is required by the Fed.

Unsurprisingly, most other developed nation yields have also come under pressure amid gathering storm clouds. We have observed a discernible shift in appetite, with many global managers actively seeking to diversify risk within portfolios. Going forward it is expected that global yields will continue to suffer a downward trajectory as the global economy weakens. Lonsec continues to favour global bonds over Australian bonds largely from a valuation and diversification perspective.

The prospect of various central banks providing additional support to financial markets is once again up for discussion, although there is no consensus view (noting in recent times Malaysia, New Zealand, Iceland and Sweden have all cut interest rates). With stubbornly low inflation in the US, geopolitical tensions with China and to a lesser degree Iran, a move by the Fed to ease pressures would not be surprising.

In Australia the rhetoric of the RBA has also changed, moving toward a more conciliatory tone, signalling there is still some room for further action if required. Looking forward, low inflation remains a key issue, as does spare capacity in the labour market. Pleasingly house prices have appeared to stabilise in Sydney and Melbourne, and the impact of further stimulus in the form of tax cuts and loosening a key constraint on mortgage credit are yet to be fully felt.

Lonsec views Australian 10-year bond yields as expensive at 1.3% and our DAA signals continue to favour other asset classes over domestic bonds. Domestic bonds rallied significantly during the quarter on the back of two RBA cuts and weakening economic data spooking local investors. The Australian dollar also proved volatile over the quarter, breaking out of the tight trading range of the past year. Going forward the Australian dollar is expected to come under increasing pressure as lower rates begin to bite.

Credit remains popular with active managers still favouring a bias to corporate bonds within portfolios, albeit bell-ended with more defensive positioning in sovereign bonds or cash-like assets. For the domestic market, it appears like more of the same going forward: tight spreads and limited opportunities. Once again, the popularity of relative value trades is noticeable, picking up extra basis points as and when they can.

Over the quarter, Lonsec has decreased Cash allocations from a slight overweight to a neutral position for portfolios with exposures to Alternatives and has moved the very overweight recommendation back to overweight for our traditional portfolios (excluding alternatives). We remain slightly underweight Australian bonds and neutral on global bonds. The sharp fall in US government bond yields during the June quarter was notable, but in comparison to domestic bond yields they remain attractive from a relative valuation perspective.

Managed accounts are exploding in popularity due to the clear advantages they offer licensees and their clients, but leading investment research house Lonsec has warned that advisers are gambling with their business if they don’t address potential and actual conflicts associated with in-house managed account products.

According to Lonsec, advisers must look for ways to harness the benefits of managed accounts while avoiding perceived conflicts that fall short of community expectations or risk attracting regulatory scrutiny.“

Managed accounts have the potential to create significant efficiency gains and improve investment outcomes for advice clients,” said Lonsec Head of Wealth Management Sales Tony Nejasmic. “But if advisers don’t properly address the how and why of managed accounts, they risk creating a conflict trap that puts their entire business at risk.”

Current best practice suggests that embracing managed accounts is appropriate for many clients but must be done with the client’s best interests in mind. Fundamentally this means asking some hard questions about the adviser’s investment capabilities, fee structure, and governance framework.

An empowered ASIC is taking a serious look at how the advice industry is using managed accounts, while there has been a dramatic shift in community expectations following the Royal Commission into Misconduct in the Financial Services Industry.

“The test is to picture yourself before the regulator and ask yourself if you have a clear justification for placing the majority of your clients’ funds in your own managed account products. If you’re unsure of the answer, then you’re likely not offering the best value for your clients and you’re likely not fulfilling your best interest duty.”

According to Lonsec it is essential that managed accounts are used for efficiency purposes, do not involve additional fees, are free of perceived conflicts, and utilise professional investment managers in the construction of portfolios.“

For many advisers, outsourcing the investment process to a professional manager like Lonsec is the logical approach. Lonsec is also in the market to acquire investment management rights from those groups who wish to “de-conflict” their business, said Mr Nejasmic.“

This allows them to focus on strategic investment advice that meets their client’s objectives and not trying to be both Financial Adviser and Investment Manager at the same time”.

Release ends

Bonds have been unrelenting in 2019, rising in stark defiance of investors who called a fade to the rally in late 2018, when the US Fed appeared determined to hike rates. This insatiable appetite for bonds has seen yields plummet to record lows in several markets, while the quantum of negative-yielding debt is climbing ever higher.

As the chart below shows, the market value of bonds tracked by the Bloomberg Barclays Global Aggregate Index has risen to nearly US $14 trillion and pushed above its 2016 peak. Negative-yielding bonds now make up around one quarter of the index. European safe-havens like Germany and France make up the lion’s share (if you can call it that), with more than 80% of Germany’s federal and regional government bonds in the red.

The value of negative yielding bonds has rocketed in 2019

Source: Bloomberg

Lonsec has been working with financial advice firms for over 20 years and during this time we’ve observed a wide range of investment committee structures. The thing that stands out for us is the clear link between high-functioning investment committees and investment outcomes, with people and processes being the most essential elements financial advisers and dealer groups need to get right.

While it’s tempting to think of your investment committee as serving a narrow governance function and therefore requiring a narrow set of skills, the success of your investment committee depends on its ability to draw on a broad set of skills and backgrounds, including those who can bring an outsider’s perspective to your organisation.

So what are the critical things you need to consider to set up your investment committee for success? These are our top three:

1. There must be a critical mass of members

Determining the right size for your investment committee depends on the size of your organization and the types of investment decisions you’re making. For example, if you’re making asset allocation and security selection decisions, you must have people involved in your investment committee with the appropriate skill set and expertise. Having a small, tightly-controlled committee is not appropriate if you’re managing dynamic, multi-asset portfolios or where you’re taking an active role in selecting stocks. Its also essential that your committee allows for a diversity of views and opinions. The more voices you have on your committee, the more robust your investment decisions are likely to be.

2. Clearly defined roles are essential

It’s important for each member of the investment committee to have a defined role to ensure they’re contributing to their full capacity. Each role may be linked to a member’s area of expertise (e.g. asset allocation, equities, fixed income, alternatives, etc.). If there’s a knowledge gap in your investment committee, consider whether you have the internal capability to fill this role or whether it’s worth bringing in the right expertise from outside. Clearly defined roles help to ensure greater accountability and allow members to contribute in ways where they are adding the most value to your investment decisions.

3. External expertise can enhance performance (and credibility)

Most investment committees will draw upon external experts. This may be to fill in a gap in expertise but more importantly external experts will bring different perspectives and may even challenge the views of your organization. Within Lonsec’s own investment committee process we have two external experts on our investment committee who bring significant experience and a different set of skills to the management of our portfolios. Importantly, they contribute an ‘outside’ perspective and fill in potential blind spots. We don’t pretend to know everything, and our clients would probably be concerned if we claimed otherwise. If you’re offering your clients a high-quality, actively managed investment solution, then having external decision makers involved in the process can bring peace of mind and add intrinsic value to your service.

There is no one-size-fits-all approach that can determine exactly what your investment committee should look like, but there are things you can do to improve your investment decision making and the value of your advice. Ensuring that your investment committee consists of people with relevant experience, bring a diversity of views, and have a clear mandate should be at the core of your process. Ultimately, you want to harness the specialized skills of your own investment professionals while balancing these out with a broader range of views and perspectives to avoid group think or missed opportunities. Even the most hardened practitioners need to be challenged once in a while.

It’s a challenging time for asset allocators in the current environment, which has seen asset prices and market sentiment shift quickly on the back of a single tweet. Markets in July were generally strong across most assets, but August has seen a re-emergence of trade tensions between the US and China. More importantly we have seen the yield curve invert with the 10-year US treasury falling below the 2-year treasury for the first time since 2007, which, as you may recall from the text books, has historically been an indicator of economic weakness.

In an environment where markets can rapidly change tack it is important to have a framework to anchor your asset allocation process. At Lonsec we focus on asset valuations, the market’s position in the business cycle, and other factors such a liquidity and sentiment. In the current environment we continue to seek diversifying assets such as alternatives and from a bottom-up perspective we seek investments that have the mandates to perform in different market conditions. This will become increasingly important in a market that may be potentially more volatile than we have seen in recent years and where it is difficult to have clear line of sight of the geopolitical conditions and the extent to which central banks will continue to prop-up markets in the future.

From an asset allocation perspective our main active positions remain an underweight position to Australian equities and a positive tilt to listed infrastructure and alternatives. Asset price returns in recent years have been well in excess of our long-term expectations, which has been a positive outcome for clients. We believe that the environment going forward will be more challenging with asset valuations generally within the fair to slightly expensive range and business cycle indicators trending down.

Recent market turmoil is a timely reminder to super members not to allow short-term market movements to impact their investment decisions, according to leading research house SuperRatings.

As investors deal with a renewed bout of volatility and growing uncertainty surrounding the economic outlook, recent data show that members are often better off riding the wave rather than switching out of their current investment option in favour of something safer.

After a promising start to the 2020 financial year, markets took a dive through the first half of August, with super funds likely to feel the pinch. According to SuperRatings, the median balanced option return was a promising 1.3% in July, but this has likely been reversed due to August’s fall in share markets. The return for the median growth option, with two thirds of the portfolio allocated to local and international shares, was 1.6% over the year, while the cash option returned 0.1%.

Median Balanced option returns to 31 July 2019

 Period Accumulation returns Pension returns
 Month of July 2019 1.3% 1.5%
 Financial year return to 31 July 2019 1.3% 1.5%
 Rolling 1-year return to 31 July 2019 7.2% 8.2%
 Rolling 3-year return to 31 July 2019 8.4% 9.0%
 Rolling 5-year return to 31 July 2019 7.8% 8.4%
 Rolling 7-year return to 31 July 2019 9.5% 10.6%
 Rolling 10-year return to 31 July 2019 8.3% 9.3%
 Rolling 15-year return to 31 July 2019 7.6% 8.4%
 Rolling 20-year return to 31 July 2019 7.3% 8.0%

Median Balanced Option refers to ‘Balanced’ options with exposure to growth style assets of between 60% and 76%. Approximately 60% to 70% of Australians in our major funds are invested in their fund’s default investment option, which in most cases is the balanced investment option. Returns are net of investment fees, tax and implicit asset-based administration fees.

AustralianSuper’s balanced option remains on top of the long-term returns chart, delivering 9.6% p.a. over the 10 years to the end of 31 July 2019, followed closely by Hostplus on 9.5% p.a. and UniSuper on 9.4%.

Top 10 performing funds over 10 years to 31 July 2019

Source: SuperRatings

The SR50 Balanced Index took a dive in the December quarter of 2018, only to rebound strongly through to the end of July 2019. Switching to a capital stable option at the end of December would have meant missing out on $4,384 by the end of July (for a starting account balance of $100,000).

Balanced options have bounced back
(Value of $100,000 invested over 11 months to 31 July 2019)

Source: SuperRatings

“The lesson for investors in the current market environment is that switching in response to short-term market movements is not a good idea,” said SuperRatings Executive Director Kirby Rappell.

Historically, the June quarter is the most challenging period for super, so members might be breathing a sigh of relief. Whether the worst of recent volatility is over remains to be seen, but members have reason to be optimistic. As the chart below shows, the September quarter has delivered an average return of 2.4% over the past decade, compared to the average June quarter return of 0.9%. For growth options and options focused on Australian or international shares, the results are even more pronounced. Australian share options returns have averaged 3.9% in the September quarter and -0.6% in the June quarter.

Average quarterly returns

Source: SuperRatings

“There are certainly some significant challenges facing markets at the moment and investors are forced to deal with a constantly shifting narrative,” said Mr Rappell.

“One of the key challenges facing funds and especially retirees at the moment is record low interest rates in Australia and the continual drop in bond yields. Lower interest rates mean retirees receive less income from annuities while investors start looking for riskier assets to add to their portfolio to generate the desired yield.”

Release ends


Warnings: Past performance is not a reliable indicator of future performance. Any express or implied rating or advice presented in this document is limited to “General Advice” (as defined in the Corporations Act 2001(Cth)) and based solely on consideration of the merits of the superannuation or pension financial product(s) alone, without taking into account the objectives, financial situation or particular needs (‘financial circumstances’) of any particular person. Before making an investment decision based on the rating(s) or advice, the reader must consider whether it is personally appropriate in light of his or her financial circumstances, or should seek independent financial advice on its appropriateness. If SuperRatings advice relates to the acquisition or possible acquisition of particular financial product(s), the reader should obtain and consider the Product Disclosure Statement for each superannuation or pension financial product before making any decision about whether to acquire a financial product. SuperRatings research process relies upon the participation of the superannuation fund or product issuer(s). Should the superannuation fund or product issuer(s) no longer be an active participant in SuperRatings research process, SuperRatings reserves the right to withdraw the rating and document at any time and discontinue future coverage of the superannuation and pension financial product(s).

Copyright © 2019 SuperRatings Pty Ltd (ABN 95 100 192 283 AFSL No. 311880 (SuperRatings)). This media release is subject to the copyright of SuperRatings. Except for the temporary copy held in a computer’s cache and a single permanent copy for your personal reference or other than as permitted under the Copyright Act 1968 (Cth.), no part of this media release may, in any form or by any means (electronic, mechanical, micro-copying, photocopying, recording or otherwise), be reproduced, stored or transmitted without the prior written permission of SuperRatings. This media release may also contain third party supplied material that is subject to copyright. Any such material is the intellectual property of that third party or its content providers. The same restrictions applying above to SuperRatings copyrighted material, applies to such third party content.

The ECB’s announcement of further rate cuts was the last thing Europe’s banking sector wanted to hear. Since the depths of the eurozone crisis in 2009 and the sovereign and banking crises that followed, Europe’s banks have struggled to get back onto the right footing. Despite the introduction of new capital requirements and rules to reduce the risk posed by too-big-to-fail institutions, the equity value of banks has been in steady decline.

For Germany, the banking problem is embodied by Deutsche Bank, whose failed attempt to merge with its smaller competitor Commerzbank has forced it to abandon its long-standing dream of becoming a major Wall Street player. Its only choice now is to drastically scale back its operations. The story throughout the rest of Europe is not much better. European bank PE ratios relative to the overall market are at the lowest levels since the early 1990s.

Europe’s banks are under pressure

Source: IBES, Heuristics

The IHS Markit Eurozone Composite PMI suggests that, while the services sector has seen some pickup, manufacturing remains under pressure, and in Germany has fallen into contraction. The survey indicates that GDP in the eurozone is rising at a 0.2% quarterly rate. France and Germany are likely growing at 0.2%, while Spain is slowing to 0.4% (from around 0.7%) and Italy is contracting at a 0.1% rate. Business expectations over the next year have fallen to the lowest level in around four years.

While recent market gains may be predicated on the assumption that more monetary accommodation will help avert slowing economic growth, the situation possibly spells further pain for the banks. Central banks are now in easing mode once again, and while the Fed has yet to cut rates officially, this is the market’s strong expectation – and they don’t see the Fed stopping with just one.

12% of respondents believe the Fed will cut by more that 150 bps by 2021

Source: BofA Merrill Lynch FX and Rates Sentiment Survey

What this means is that investors looking for financial services exposure need to tread carefully. For the banks, lower rates tend to mean more pressure on lending margins, which acts as a headwind to growth. While a beaten down banking sector can spell opportunity for investors, from a portfolio perspective it’s essential to think carefully about what sort of exposure you’re looking for. For those seeking value in the banks, be prepared for a period of pain if the low rate environment continues.

Any value manager will tell you that the past 10 years has been a challenging period. Not only have growth shares outperformed, but the dispersion in price performance between the two styles is currently the widest it’s been over this period. Looking at the performance of the MSCI value and growth indices (see chart below), it’s tempting to conclude that value is all but dead.

Value is beaten down over the past decade

Value vs growth period returns, % p.a.

Source: FE, Lonsec

The reason for this dispersion starts to make sense when you think about what it is the value and growth investing styles represent. Value style investing seeks to identify companies trading below their intrinsic value. Value investors tend to be focused on long-term performance, believing that the companies they invest in will tend towards their intrinsic value over time.

Conversely, growth style investing focuses on companies whose earnings are expected to grow in excess of the market. Growth investors are typically willing to pay a premium for this growth, believing that the earnings trajectory will continue to rise and support equity prices. There are numerous studies suggesting that over the long-term the value approach outperforms growth, with well-known investors and academics such as Ben Graham and Warren Buffett being notable proponents of value style investing. The chart below compares the performance value and growth across the globe over a 20-year period

Value and growth are neck and neck over 20 years

Growth of $10,000

Source: FE, Lonsec

So why has value style investing lagged growth over the past decade? Like all things related to markets the answer is not simple, but there are some things we can point to. Firstly, the low interest rate environment which followed the global financial crisis in 2008 has benefited growth companies. Growth companies that are expected to grow their free cashflow in the future are typically more sensitive to interest rates, in a similar way to a long duration bond. With interest rates at low levels and continuing to fall in some markets, growth stocks have continued to perform well.

Secondly, global equity markets, including the US, have been fuelled by the strength of high growth sectors such as the technology sector with the so called FAANG stocks (Facebook, Apple, Amazon, Netflix and Alphabet), which have until recently driven a significant portion of US market returns. Australia is not to be outdone with its own version of growth darlings – the so-called WAAX stocks (Wisetech Global, Afterpay, Altium, Appen and Xero).

Increasingly, investors are questioning the ‘value’ of value style investing and whether it can deliver for investors in the current environment. The last time similar questions were asked was in the 1990s when markets were dominated by high-growth tech companies trading at high price-to-earnings multiples and investors were fearful of deflation. While the environment is different today (many tech companies are supported by actual earnings and interest rates are at record lows thanks to ‘unconventional monetary policy’), value investing is a long-term investment approach and will inevitably experience extended periods of relative underperformance versus growth.

It’s safe to say value is currently out of favour given the dispersion between value and growth stocks is widening. However, from a portfolio perspective, being over-exposed to a single factor or investment style can be risky if market conditions change. Being aware of your portfolio biases by engaging in deep investment due diligence on individual fund manager teams and investment products is a critical element when building a quality portfolio. Assuming that current market dynamics will continue into perpetuity is dangerous, particularly in a market where volatility is on the rise and the ‘status quo’ can shift rapidly.

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IMPORTANT NOTICE: This document is published by Lonsec Investment Solutions Pty Ltd ACN: 608 837 583 (LIS), a Corporate Authorised Representative (CAR number: 1236821) of Lonsec Research Pty Ltd ABN: 11 151 658 561 AFSL: 421 445 (Lonsec Research).  LIS creates the model portfolios it distributes using the investment research provided by Lonsec Research but LIS has not had any involvement in the investment research process for Lonsec Research. LIS and Lonsec Research are owned by Lonsec Fiscal Holdings Pty Ltd ACN: 151 235 406. Please read the following before making any investment decision about any financial product mentioned in this document.

Disclosure at the date of publication: Lonsec Research receives a fee from the relevant fund manager or product issuer(s) for researching financial products (using objective criteria) which may be referred to in this document. Lonsec Research may also receive a fee from the fund manager or product issuer(s) for subscribing to research content and other Lonsec Research services.  LIS receives a fee for providing the model portfolios to financial services organisations and professionals. LIS’ and Lonsec Research’s fees are not linked to the financial product rating(s) outcome or the inclusion of the financial product(s) in model portfolios. LIS and Lonsec Research may hold any financial product(s) referred to in this document. LIS and Lonsec Research’s representatives and/or their associates may hold any financial product(s) referred to in this document, but details of these holdings are not known to the Lonsec Research analyst(s).

Warnings: Past performance is not a reliable indicator of future performance. Any express or implied rating or advice presented in this document is limited to “general advice” (as defined in the Corporations Act 2001 (Cth)) and based solely on consideration of the investment merits of the financial product(s) alone, without taking into account the investment objectives, financial situation and particular needs (“financial circumstances”) of any particular person. Before making an investment decision based on the rating or advice, the reader must consider whether it is personally appropriate in light of his or her financial circumstances or should seek independent financial advice on its appropriateness.  If the financial advice relates to the acquisition or possible acquisition of a particular financial product, the reader should obtain and consider the Investment Statement or the Product Disclosure Statement for each financial product before making any decision about whether to acquire the financial product.

Disclaimer: This document is not intended for use by a retail client or a member of the public and should not be used or relied upon by any other person. No representation, warranty or undertaking is given or made in relation to the accuracy or completeness of the information presented in this document, which is drawn from public information not verified by LIS.  Financial conclusions, ratings and advice are reasonably held at the time of completion (refer to the date of this document) but subject to change without notice. LIS assumes no obligation to update this document following publication. Except for any liability which cannot be excluded, LIS and Lonsec Research, their directors, officers, employees and agents disclaim all liability for any error or inaccuracy in, misstatement or omission from, this document or any loss or damage suffered by the reader or any other person as a consequence of relying upon it.

Copyright © 2019 Lonsec Investment Solutions Pty Ltd ACN: 608 837 583

Important information: Any express or implied rating or advice is limited to general advice, it doesn’t consider any personal needs, goals or objectives.  Before making any decision about financial products, consider whether it is personally appropriate for you in light of your personal circumstances. Obtain and consider the Product Disclosure Statement for each financial product and seek professional personal advice before making any decisions regarding a financial product.