In recent years it seems that market sentiment is shifting more rapidly than ever. We saw this earlier this year when the US Federal Reserve flipped on its monetary stance from a tightening stance to a “let’s take pause and see how things pan out” position.  In August we saw the yield curve invert meaning that long-term bond yields were lower than short-term bond yields. The most common measure of this is the difference between 2 and 10 year government bond yields. Markets reacted negatively to this as an inverted bond yield is typically an indication that investors are concerned about the economy. It has also been a good predictor of a looming recession with an inverted yield curve preceding every US recession since the 1970s. Interestingly, the time between the yield curve inverting and a recession is highly variable and equity markets have historically performed strongly until a recession has hit. For example, in 1988 the S&P 500 rose by over 30% prior the recession and in 2006 it rose approximately 16%. The yield curve has since steepened and is no longer inverted. So does this mean we are out of the woods?

From our perspective the economic news is mixed. Indicators such as manufacturing data have been trending down, however housing has been strong in the US and has improved in Australia. Consumers are also holding up in the US. Geopolitics continue to be an X-factor with news regarding US – China trade talks continually shifting, whilst the prospect of further quantitative easing is certainly plausible. From a bottom-up perspective, many of the professional investors Lonsec speaks to are indicating that they don’t expect a recession within the next 12 months but over a 2 year timeframe the risk of recession rises.

Amidst this uncertain backdrop, from an asset allocation perspective we have retained our slight defensive bias holding a greater exposure to real assets and focusing on diversification via uncorrelated assets such as alternatives.

Private markets have long been the domain of institutional investors. With benefits such as higher return potential, lower volatility, lower correlation to traditional listed assets, and enhanced diversification, it’s not hard to see why they are so attractive. Institutional investors such as super funds have been steadily increasing their exposure across the private market spectrum, which includes equity, real estate, infrastructure and debt.

Private markets by their nature require significant long-term commitments (in some cases capital can be locked up for ten or more years) and have significant barriers to entry given the large amounts of capital required. Both factors have traditionally made it difficult for retail investors to access the benefits of private markets, but this is quickly starting to change.

Private asset managers are exploring ways to make investing in private markets more accessible to retail investors by introducing greater liquidity and reducing minimum investment sizes. Along with slowing economic growth and the continued hunt for yield, this is making private markets an increasingly viable and attractive opportunity for retail investors and SMSFs seeking greater portfolio diversification.

Lonsec has seen an uptick in private market vehicles targeting retail investors coming to market over the last 12–18 months. Of particular note is the increased interest in private market funds (both equity and debt) being offered under ASX listed structures such as Listed Investment Trusts (LITs).  Such structures have been common in the UK and the US for some time but are a relatively new development in the Australian market.

Offering private assets through a LIT structure provides several benefits to retail investors, including:

  • The ability to create a diversified portfolio of unlisted assets with no minimum investment size;
  • Access to private markets in a more liquid investment structure, with investors able to buy and sell units via the ASX;
  • A greater focus on the long-term investment strategy. Because LITs are closed-end vehicles, managers are less concerned about funding applications and redemptions, which has the potential to boost returns compared to an open-end pooled vehicle;
  • No requirement to manage commitments to fund future investments. Capital is paid upfront and invested in the LIT from day one, so there are no additional capital calls for the investor.

However, as we all know, rarely do investors come across a free lunch, especially in the retail world. Trade-offs must be expected and managed in order to get the most value out of any asset class, and private markets are no different. When including private market assets in a portfolio, it’s important to think about the following:

Private market assets are illiquid

Private assets are by their nature highly illiquid, and investors wishing to redeem may have to do so at a discount to Net Asset Value (NAV). It’s important to treat an investment in private markets as a long-term investment, irrespective of the structure in which it’s offered. Investors wanting (or worse, needing!) to sell LIT units in periods of market stress, when many investors are heading for the door, may face significant discount to NAV. It’s important to ensure the private asset manager has policies in place for managing these discounts should they arise.

Expect some volatility along the way

Private assets offered in LITs will have a higher correlation to the broader equity market and are more volatile than traditional private asset investments. By offering private assets in a listed structure, market beta is introduced, exposing investors to swings in sentiment in a similar manner to any other security listed on the ASX. Volatility risk may also arise when units in the LIT are thinly or heavily traded, which could make the unit prices very volatile regardless of changes in the underlying value of the investments held by the LIT.

It takes time to become fully invested

Unlike traditional private assets, where commitments are drawdown over time, investors in private market LITs pay their capital upfront in exchange for units. Private asset managers don’t invest 100% of that capital immediately, but instead wait for investment opportunities to arise. Consequently, it may take between 12 months to four years to reach the target portfolio allocations. During this ‘ramp-up’ period, private asset managers will invest in other liquid assets ranging from cash through to credit or even equities. This ensures investors are generating a reasonable return or income from an early stage while the portfolio is getting set.

However, it does of course introduce other risks and exposures. It’s important to understand what assets you will be exposed to during the ramp-up phase, as this will impact your returns (and risk). You may not be getting the exposures you expected for some time.

Lonsec believes retail investors can benefit from investing in private markets, but they need to be mindful of the trade-offs when investing via listed vehicles. Retail investors’ needs are inherently different from those of institutional investors—they typically have shorter time frames, a greater need for liquidity, and smaller amounts of capital to invest. While private asset managers have sought to meet a number of these needs in recent years, there’s no panacea for investing in what are inherently illiquid, long-term assets. Retail investors need to ensure that investing in private markets via LITs aligns to their long-term objectives and risk appetite.

Many behavioural studies have shown there are several traits and biases that can impede us from making reasonable decisions about everything from what to eat to how to invest. Understanding these biases and considering whether they may be negatively impacting decisions can be beneficial when implementing long-term investment plans. These studies show, in general, people have asymmetric risk profiles and fear losses more than the expectation of gains by at least a 2:1 margin[1]. Interestingly, and perhaps not surprisingly, this ratio increases substantially as people approach retirement.

American psychologist and economist, Daniel Kahneman, who won a Nobel Prize for his work challenging the prevailing assumption of human rationality in modern economic theory has stated, ‘If you have an individual whose objective is to maximise wealth at a certain future point in time, then loss aversion is very bad because loss aversion will cause that individual to miss out on many opportunities.’

This loss avoidance trait stands in contrast to a basic investment principal, that investors need to accept higher risk (and higher potential for near-term losses) in order to achieve higher returns over the long term, particularly during market sell-offs. When faced with losses, rational decision-making can become impaired by the emotional desire to avoid more losses.

There are a wide range of cognitive biases that can impact retirement plans, some are listed below:

Confirmation bias

Confirmation bias is the natural human tendency to seek information that confirms an existing point of view or hypothesis. This can lead to overconfidence if investors keep seeing data that appears to confirm the decisions they have made. This overconfidence can result in a false sense that nothing is likely to go wrong, increasing the risk of being blindsided when something does go wrong.

Information bias

Information bias is the tendency to evaluate information even when it is useless in understanding a problem or issue. Investors are exposed to an array of information daily, and it is difficult to filter through this and focus on the relevant information. In general, investors would make superior investment decisions if they ignored daily share price movements and focused on prices compared to the medium-term prospects for the investments. By ignoring daily share price commentary, investors would overcome a dangerous source of information bias in the investment decision making process.

Loss aversion bias

Loss aversion is the tendency for people to strongly prefer avoiding losses than obtaining gains. The loss aversion effect can lead to poor and irrational investment decisions, where investors refuse to sell loss-making investments in the hope of making their money back. Investors fixated on loss aversion can miss investment opportunities by failing to properly consider the opportunity cost of their investments.

Anchoring bias

Anchoring bias is the tendency to rely too heavily on, or anchor to, a past reference or one piece of information when making an investment decision. For example, if you were asked to forecast a stock’s price in three months’ time, many would start by looking at the price today and then make certain assumptions to arrive at a future price. That’s a form of anchoring bias – starting with a price today and building a sense of value based on that anchor.

How do we try and overcome the biases when building retirement portfolios?

The objective based nature of Lonsec’s Retirement portfolios means there is a greater focus on absolute rather than relative performance. Additionally, the portfolios have been constructed to manage risks, including:

  • Market and sequencing risk
  • Inflation risk
  • Longevity risk

Some investment strategies that can assist in controlling for these risks include:

Variable beta strategies can vary equity market exposure by allocating to cash in periods where equity market opportunities are perceived to be limited due to expensive valuations, or where market downside risk is considered high.

Long / Short – Active Extension (also known as 130/30 funds) utilise a broad range of strategies including short selling and adjusting the net equity position for performance enhancement, risk management and hedging purposes.

Multi-asset real return funds invest in a wide range of asset classes, with the managers having considerable flexibility in the type and percentage of asset classes allocated to. Typically, these funds will seek to limit downside risk, while also targeting a real return i.e. a CPI + objective.

Real assets such as property and infrastructure, commodities and inflation linked bonds can assist in managing against inflation risk.

When constructing the Retirement portfolios, Lonsec takes a building block approach by assigning a role for each fund – yield generation, capital growth and risk control.

The yield component of the portfolios generate yield, or a certain level of income from investments that have differing risk return characteristics. The capital growth component is designed to generate long term capital growth, with limited focus on income, and is more suited to early retirees. The risk control component is critical for retirement portfolios and is designed to reduce some of the market risks in the yield and capital growth components. It is important to note that the risk control part of the portfolios will not eliminate these risks but aims to mitigate them. Asset allocation and diversification are also important ingredients in managing the overall volatility of the portfolios.

The Retirement portfolios can assist in managing the risks that impact retirees, however it is important to note that none of these strategies provide a guaranteed outcome. The range of products that offer certainty of income or capital protection such as annuities has increased in recent years, in recognition of Australia’s aging demographics and demand for greater certainty in retirement. Separate guidance on the use of annuities is available from Lonsec.

 

[1] Gachter, Johnson, Herrmann (2010). Individual – level loss aversion in riskless and risky choices. Columbia Business School

Thankfully my kids have moved on from their ‘Frozen’ phase and the tunes of ‘Let it go’ are well and truly buried away in the back of the DVD cabinet. As professional investors, one of the biggest challenges we face is when to ‘let it go’. When we make an investment into a stock or managed fund the investment rationale is clear, attractive valuations, positive earnings growth, solid investment team, appropriate investment style. However, what happens when our investments don’t follow the course we anticipated and perform poorly? An even more difficult decision is when to let go of a ‘winner’?

Behavioural factors play a big role in terms of how people react to events and the subsequent decisions they make. The belief that things will turnaround, the comfort of the pack (we all go down together), ‘falling in love’ with an investment. Such emotions impact all of us even the most experienced investor. The main line of defense to minimise the impact of behavioural factors in a decision making process is to always point back to your investment philosophy and the underlying process which underpins that philosophy. If your overall philosophy is one of generating returns with lower downside risk than the market do the underlying investment align to this philosophy? have they provided downside protection? if not, why? (are there cyclical reason for this or is there something structural impact the return profile). If an investment has provided this type of return profile what have been the factors contributing to this e.g. certain sector or country exposures, and do you expect these factors to work in the future? If we use a managed fund as an example it is important to look out for any changes to how the manager is managing money which may be reflected in a change in the risk and return profile of a fund. Is there a change in how the manager positions their investment approach to what they communicated a few years ago?

The main forum for our manager and stock decisions for our managed portfolio are our Manager and Security Selection Investment Committees.  The committees are made up of senior members of our Research and Investment Consulting teams, our CIO as well as our external experts. Decisions to ‘let an investment go’ are made via the committee process. Investment recommendations are supported by qualitative and quantitative analysis. If we use managed funds for example this would include meeting with the manager (outside of the formal annual review process) focusing in on the issues at hand and targeted quantitative analysis which may provide a clue as to where the problem rests, an example being where a manager has taken stock-specific risk which is uncharacteristic of the manager.

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.