Active management has fallen out of favour among investors, reflecting changing investor preferences and the scars of the Global Financial Crisis, which have led investors to shun stock pickers and more elaborate strategies in favour of lower-cost, vanilla products. Investors today are focused far less on alpha generation, with its goal of outperforming benchmarks, and are now far more content in generating the majority of their returns from index funds or similar passive strategies.

The growth in passive management has been astonishing. In the last five calendar years, investors moved US$1.5 trillion into funds managed by Vanguard, one of the world’s largest managers of passive strategies. Blackrock, the second largest passive manager, took in US$685 billion over the same period. Vanguard now manages close to US$4.0 trillion globally in passive strategies and on average owns around 7% of every listed US company, according to Bloomberg data. As passive managers continue to suck up funds, active managers are struggling to get a positive message through.

Passive managers don’t apply any security selection, meaning the money simply flows into passive or index strategies that replicate benchmarks like the S&P/ASX 300 Index in Australia or the S&P 500 Index in the United States, with Exchange Traded Funds making it easier than ever before for investors to gain relatively cheap passive exposure.

At its core, passive investing is a momentum strategy. It buys more of those stocks that go up in price and sells more of those that fall in price. Passive strategies tend to work best when financial markets experience strong upward moves in share prices. Passive management is used mostly in the portfolio management of equities (Australian, Global and Emerging Markets) and fixed income (Australian and Global) and have given rise to the major ETF providers that currently dominate the market (see chart below).

FUM share of Australia’s major ETF providers (August 2019)

Source: ASX, Lonsec

The beta rally has put active managers in the shade

The post-GFC period has been characterised by strong equity market returns, but given the length of the bull market to date, investors are questioning how long this situation can last.

Given the inevitable cyclicality of financial markets, the one thing that’s certain is that strong markets will not last forever. In a low return environment, market beta may end up providing disappointing returns, making alpha a valuable contributor to portfolios.

The aim of active management is to be an additional incremental return source, above market returns. Alpha doesn’t scale well with beta, meaning it becomes a smaller percentage of returns when beta is very high. This is the environment we find ourselves in, so we would expect beta to do well and for seekers of alpha to struggle. But even taking a broader view, the case for active management does not appear great.

The hard truth is that most active fund managers underperform benchmarks constructed by index committees. One of the world’s most widely used benchmarks for assessing US equity fund performance is the S&P 500 index. The committee looks at only a handful of criteria when looking to add new stocks to the index, including: liquidity, financial viability (four consecutive quarters of positive earnings), market capitalisation (must be greater than US$6.1 billion), and sector representation (the committee tries to keep the weight of each sector in balance with sector weightings of the S&P Total Market Index of eligible companies). Changes to the index are made when needed.

The S&P committee does no macroeconomic forecasting, invests over a long-term horizon with low portfolio turnover, and is unconstrained by sector or industry limitations, position weightings, investment style, or performance pressures. Yet this straightforward strategy has generally outperformed active fund managers.

Some active managers can consistently outperform

If alpha were easy to find, it wouldn’t exist. There are three general sources to generate excess return for investment portfolios: strategic asset allocation, tactical tilts within asset classes (including opportunistic investing), and superior fund manager selection. While opportunistic investments tend to be episodic alpha generators in portfolios, the biggest long-term drivers of alpha are asset allocation and manager selection.

Even as managers have struggled to generate alpha, a significant number of managers are still generating returns in excess of market indices. The key is having the right resources and the right approach to find them. Average active fund managers tend to underperform industry benchmarks, but the best fund managers outperform over longer time frames.

There’s a deep body of research that looks at how investors can gain an edge by identifying active fund managers that are able to tap sustainable sources of alpha. Research indicates that to meaningfully outperform, it is often helpful to find active fund managers with a portfolio that looks significantly different to the benchmark they are attempting to beat (i.e. they have a high degree of ‘activeness’).

In the financial literature, there are numerous studies showing that the average active fund manager underperforms the benchmark index after fees. However, research presented in 2006 by Martijn Cremers and Antti Petajisto of the Yale School of Management introduced an idea called Active Share. This is a new method of measuring the extent of active management employed by fund managers and is a useful tool for finding those that can consistently outperform. By analysing 2,650 US equity funds from 1980 to 2003, Cremers and Petajisto found that the top-ranking active funds—those with an active share of 80% or higher—beat their benchmark indices by 2.0–2.7% p.a. before fees and by 1.5–1.6% p.a. after fees.

Active share aims to measure the proportion of a manager’s holdings that are different to the benchmark. It is calculated by taking the sum of the absolute value of the differences of the weight of each holding in the manager’s portfolio versus the weight of each holding in the benchmark index and dividing by two. For a long-only equity fund, the active share is between 0% and 100%. The active share for fully passive strategies that replicate an index is 0%, and more than 90% for strategies that are very different to the benchmark index.

As you might expect, the portfolios of active, high-conviction fund managers will diverge significantly from the benchmark, and will frequently incur volatility relative to benchmark returns. However, this differentiation provides investors with the opportunity to add value over the long term.

What to look for when assessing active managers

Skilled managers with high active share have shown a higher tendency to outperform the market. Investors that tilt towards active managers with high active share have a greater chance of outperforming. They tend to be smaller fund management organizations, often where the founder is an investor first and invests his or her wealth alongside external clients, bringing their investing acumen to a portfolio of funds.

Active managers with high active share tend to maintain this high level consistently over time. This proves useful when conducting analysis to help identify managers that are likely to outperform in the future as well. While some of these managers may not have beaten the index in recent periods, when there are dislocations in markets, these managers will be well positioned to generate long-term returns above the fees they charge.

Active share by itself does not indicate whether a fund will outperform an unmanaged benchmark. There are other important aspects to consider when conducting manager due diligence. Here are a few things you should consider:

  • Find out as much as you can about the fund’s culture and process. Outperformers see investing as a profession and not a business. Examine the fund’s investment philosophy to see if it is consistent and lived out through the fund’s investment decisions. Does the manager exercise patience and discipline?
  • Successful active fund managers have low portfolio turnover with long holding periods of at least four years versus roughly one year for average performing funds. This is a useful metric to look at when assessing a fund’s buy/sell discipline. Another strong indicator is for active managers to add to stock holdings when market pricing improves, rather than giving in to agency behaviour of selling into a falling market.
  • Alpha generators are high conviction stock pickers. This means their portfolios are concentrated in their best ideas, leading to a higher level of ‘activeness’ and differentiation from the benchmark.

While there are active managers that are persistently generating alpha, finding them is not a simple task. For investors that are committed to generating long-term outperformance, it’s critical to have the right resources in place to identify these managers. A world class research effort is required to be able to identify and evaluate those managers that can generate consistent outperformance from the thousands of managers out there.

Historically, high valuations in a range of asset classes including equities, sovereign bonds, credit and unlisted assets mean future beta returns are expected to be lower. This will make it a challenging environment for investors to meet their investment objectives. For those with the knowledge and capacity, finding alpha can help bridge the gap.

When accumulating savings for retirement, the investment objective is clear – to grow and maximise savings. Risk in the accumulation phase is also well-defined and focused on the loss of capital, as measured by the volatility of investment returns or related downside risk measures. Risk tolerance is then typically used to determine appropriate investment profiles, with the aim of achieving greater wealth to fund retirements.

However, the risk-return landscape becomes significantly more complex once retirement comes into the picture. The primary objective in the decumulation phase ceases to be pure growth and more about using accumulated wealth to sustain a target level of income throughout retirement. Therefore, volatility of investment returns is no longer a suitable risk measure as it does not describe the risk of failing to meet this objective.

Retirement income risk measure

Traditional measures of variance (standard deviation) focus on both upside and downside variation. However, behavioural economists commonly point out that individuals are more averse to downside variation than upside variation. A more relevant risk measure in the context of decumulation is the probability of running out of money, or a measure of income variation. This captures important dynamics such as the sequence of returns, which can be particularly damaging in decumulation.

The risk can be depicted as:

 

The importance of risk measurement in retirement products is highlighted in a Treasury consultation paper which proposes a range of standard metrics to help consumers make decisions about the most appropriate retirement income product for their own circumstances.

The discussion paper proposes that a measure of income variation be provided in respect of all retirement income products and this measure is presented on a seven-point scale.

The finance industry uses terms like longevity risk, market risk, sequencing risk and inflation risk, which are all relevant to the outcome experienced by investors in a retirement income product. However, these terms are not well understood by a lay person, so an income variation measure could help fill in some gaps.

Retirement objectives

Lonsec’s Retirement Lifestyle Portfolios are objectives-based portfolios focused on delivering a sustainable level of income in retirement, as well as generating capital growth. Specifically, the portfolios are designed to assist advisers in constructing portfolios to meet retiree essential and discretionary income needs, while generating some capital growth to meet lifestyle goals.

Differences to Lonsec’s core accumulation model portfolios are:

  • Income objective of 4% p.a. for all portfolios
  • Greater bias to AUD denominated assets – historically higher dividends, franking credits
  • Greater focus on absolute rather than relative performance
  • Constructed to manage capital drawdown risk
  • Fixed income allocations have less duration and greater credit exposure
  • Key building blocks are Yield, Capital Growth & Risk Control

In reality, risk in retirement is multi-dimensional. An individual retiree may have multiple goals, such as leaving a bequest, with a different level of importance attached to each. An individual’s risk aversion in retirement will therefore be defined by a holistic view of their retirement goals, and the risks to those goals across all scenarios that could play out during retirement. Typically, more than one risk measure is necessary, with multiple scenarios required to truly appreciate the risks inherent with each solution.

A combination of factors has created fertile ground for market volatility, resulting in a bumpy ride for super members, who have experienced six negative monthly returns over the past year.

According to SuperRatings, the median balanced option return for August was an estimated -0.5%, with the negative result driven by a fall in Australian and international shares. The median growth option, which has a higher exposure to growth assets like shares, fared worse, returning an estimated -0.9%.

In contrast, the median capital stable option, which includes a higher allocation to bonds and other defensive assets, performed more favourably with an estimated return of 0.3% (see table below).

Estimated accumulation returns (% p.a. to end of August 2019)

1 month 1 year 3 years 5 years 7 years 10 years
SR50 Growth (77-90) Index -0.9% 5.2% 8.8% 8.0% 10.2% 8.5%
SR50 Balanced (60-76) Index -0.5% 5.3% 8.0% 7.5% 9.2% 8.0%
SR50 Capital Stable (20-40) Index 0.3% 5.3% 4.8% 4.8% 5.4% 5.7%

Source: SuperRatings

Investors were caught off guard in August as trade negotiations between the US and China broke down, while a range of geopolitical and market risks, including further signs of a slowing global economy, added to uncertainty.

In Australia, a disappointing GDP result for the June quarter revealed a domestic economy in a more fragile state than previously acknowledged. Action from the Reserve Bank to lower interest rates is expected to assist in stabilising markets but could be detrimental for savers and retirees who rely on interest income.

Pension products shared a similar fate in August, with the balanced pension option returning an estimated -0.6% over the month while the growth pension option returned an estimated -1.0% and the capital stable pension option was mostly flat with an estimated return of 0.3%. Long-term returns are still holding up well, with the median balanced option for accumulation members delivering 9.2% p.a. over the past seven years (in excess of the typical CPI + 3.0% target) and the median balanced pension option returning 10.2% p.a.

Estimated pension returns (% p.a. to end of August 2019)

1 month 1 year 3 years 5 years 7 years 10 years
SRP50 Growth (77-90) Index -1.0% 5.9% 9.9% 9.2% 11.5% 9.4%
SRP50 Balanced (60-76) Index -0.6% 6.2% 8.7% 8.0% 10.2% 8.8%
SRP50 Capital Stable (20-40) Index 0.3% 6.2% 5.5% 5.5% 6.3% 6.4%

Source: SuperRatings

“There will always be negative months for super members, but the timing of negative returns can have a real impact on those entering the retirement phase,” said SuperRatings Executive Director Kirby Rappell.

“For members shifting their super savings to a pension product, a number of down months in relatively quick succession will mean they begin drawing down on a smaller pool of savings than they might have anticipated. As members get closer to retirement, it’s important that they review their risk tolerance to make sure they can retire even if the market takes a turn for the worse.”

As the chart below shows, down months in the latter part of 2018 took their toll on pension balances, although they were able to recover through 2019 to finish above their starting value by the end of August 2019.

Pension balance over 12 months to end August 2019*

Pension balance over 12 months to end August 2019
Source: SuperRatings
*Assumes a starting balance of $250,000 at the end of August 2018 and annual 5% drawdown applied monthly.

Comparing balanced and capital stable option performance shows that the balanced option suffered a greater drop but was able to bounce back relatively quickly. A starting balance of $250,000 fell to $232,951 over the four months to December 2018, before recovering to $252,091 at the end of August 2019.

In contrast, the capital stable option was able to better withstand the market fall, with a starting balance of $250,000 dropping to only $241,746 in December before rising back to $252,201.

While both performed similarly over the full 12-month period, a member retiring at December 2018 could have been over $8,500 worse off if they were in a balanced option compared to someone in a capital stable option. While a capital stable option is not expected to perform as well over longer periods, it will provide a smoother ride and may be an appropriate choice for those nearing retirement.

“Super fund returns have generally held up well under challenging conditions, but there’s no doubt this has been a challenging year for those entering retirement,” said Mr Rappell.

“Under these market conditions, timing plays a bigger role in determining your retirement outcome. At the same time interest rates are at record lows and moving lower, so the income generated for retirees and savers is less, particularly if someone is relying on interest from a bank account. In the current low rate and low return environment, it’s harder for retirees to generate capital growth and income.”

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.

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

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.

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.

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.

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