While the use of a value approach or value (factor) bias is often associated with equity portfolios, the extraordinary events in early 2020 served as a reminder of the value bias inherent in many multi asset solutions. This bias results from the valuation factors inherent in both asset allocation and security selection decisions.

The emphasis managers place on ‘value’ in their asset allocation and security selection processes has impacted portfolio performance over the past several years given the headwinds ‘value’ as a factor has faced. Lonsec’s recent review of multi-asset funds emphasised the need for adequate risk management systems to ensure any ‘bets’ in the portfolio are intended and in line with managers’ strategic decisions. Moreover, Lonsec was interested to discuss the role of ‘value’ in asset allocation decisions alongside other factors including liquidity, sentiment and policy, and the timeframe in which managers frame their decisions.

In this thought piece Lonsec aims to answer why the last five years has been a challenge for asset allocators, the role the ‘value’ factor has played and why Lonsec believes it is vital that asset allocators and their investors understand the drivers and extent of any bias’s present in portfolios and the likely effect this will have on portfolio performance at different points in the cycle.

Asset allocation

Investment managers who build diversified portfolios of assets with allocations to an array of asset classes (i.e., multi asset portfolios) often use an asset allocation approach as the core building block of their portfolio construction process.

While there are numerous asset allocation approaches, the most recognised are long term ‘strategic asset allocation’ (SAA), medium term ‘dynamic asset allocation’ (DAA) and short term ‘tactical asset allocation’ (TAA). While some managers have defined their own asset allocation approach and associated acronym, their approaches invariably sit somewhere between long term SAA and short term TAA.

For managers who build portfolios based on a clearly defined asset allocation approach, capital market assumptions (i.e., forecasts for asset class returns, asset class risks and cross-asset correlations) are key inputs into the setting of portfolio asset allocation, regardless of the approach used.

When defining capital market assumptions for the forecast period, asset allocators commonly use expected returns, expected risk and correlations as the essential inputs into the asset allocation process. For SAA decisions, expected returns are heavily reliant on current valuations. DAA processes by contrast focus on medium term horizons of circa 18 months to 3 years and can focus on broader factors in determining the under and overweights to particular asset classes. In Lonsec’s experience, valuation will still play a role, and in some cases a heavy role, in determining positioning over these periods. For example, if equity markets are deemed to be trading at high valuations relative to long term averages (e.g., on metrics such as price to earnings multiples), asset allocators may choose to down-weight equities in their current asset allocation. This decision may be driven by the assumption valuation multiples will normalise in the ensuing period towards the long-term average (e.g., where a compression in earnings multiples drives a fall in share prices). Likewise, in the fixed income sphere, low yields and narrow spreads have meant allocating to these sectors has been a challenge. The difficulty with this approach is that valuations can overshoot for an extended period of time, especially when liquidity is higher than average and central bank policy has been supportive. The use of valuation metrics as inputs in asset allocation approaches is likely to create a bias towards asset classes offering attractive valuations and in turn creating value biases in multi asset portfolios.

The dominance of macro factors in overshadowing asset specific factors has continued to be a discussion point between Lonsec and multi-asset managers. Lonsec has found those using a framework to assess the economic and market cycle to have a more holistic DAA framework when compared to others using more simple methodologies.

Security selection

Alongside asset allocation, another dominant driver of positioning for multi asset managers is security selection. Having identified the desired portfolio asset class exposures, in order to select the securities for inclusion in each asset class managers will often analyse the prevailing valuation levels of securities or sectors. This analysis can involve drilling down to the sub asset class level, geographical location level, and the sector/industry level to find the best opportunities within an asset class.

While some managers may seek to build portfolios with diversified factor exposures, many managers tilt security selection away from seemingly expensive areas of securities markets and towards undervalued areas of securities markets.

As Figure 1 shows, entering 2020 the valuation gap between growth equites and value equities had moved to highs not seen since the early 2000’s bubble:

Figure 1

While increasing exposure to cheaper areas of securities markets makes sense intuitively, where multi asset managers apply this approach across many of or all the underlying asset classes utilised, it may create a large value factor bias within portfolios. Lonsec believes managers need to be aware of these biases and ensure exposures are intended rather than unintended positions.

The last five years, and heading into 2020

In the years after the GFC, having taken official cash rates to record lows, the modus operandi of central banks has been to pump liquidity into economies and investment markets at any and every sign of trouble. This has helped to drive down bond yields and expected returns across all asset classes. The challenge of where to invest in this environment has been one impacting all asset allocators.

While managers have stuck to their investment and portfolio construction processes over this time, Lonsec notes there has been a disconnect between portfolio positioning and financial market performance. The challenge for managers over this period was to correctly form a view on the business cycle. With interest rates rising (albeit slowly) from late 2015 to 2018 and contrasting views on the emergence of inflation, there were divergent views on how portfolios should be positioned (over this period Lonsec has noted funds in its Variable Growth Assets > Real Return sector have been positioned at both ends of the risk spectrum). Likewise, views on the market cycle becoming later stage were predicated on valuations becoming more expensive across the board. Many of the managers we rate had been conservatively positioned due to this, and underperformed passive benchmarks which benefitted from the continued and increasing richness of valuations (particularly in geographies like the US, and sectors like Technology and Healthcare).

While there were signs of a pick-up in economic growth and a corresponding response from value and cyclical assets in late 2019 and some managers became more constructive on market outcomes, the three-year period leading into January 2020 undoubtably favoured strategies that invested in growth assets over value assets, as shown in Figure 2:

Figure 2

The 2020 experience – the bear market

The COVID induced sell off that began in February 2020 saw value stocks fall faster and further than growth stocks through late March 2020. Value orientated strategies have at times underperformed at the beginning of equity bear markets, arguably as investors throw in the towel and finally pull the sell trigger on their worst performing stocks, and this was the case in 2020. Figure 3 shows that from 1 Jan 2020 to 20 May 2020, the performance of value stocks materially lagged that of growth stocks.

Figure 3

Figure 4 shows that the valuation gap between growth equities and value equites continued to reach new multi-year highs during and coming out of the COVID induced bear market:

Figure 4

The 2020/21 experience (so far) – multi asset managers

The chart in Figure 5 shows the experience of a sample of managers in the Variable Growth Assets – Real Return sub-sector. While some multi asset managers suffered smaller drawdowns relative to peers by entering February 2020 defensively positioned based on valuations (and had been conservatively positioned for much of the prior two to three year period), other multi asset managers nimbly reduced risk exposures by reducing equity exposures or adding downside protection through derivatives.

Among the managers that suffered larger drawdowns relative to peers, many had pronounced value biases through their asset allocation and security selection approaches, in some cases adding significantly to cheap, cyclicals as the market sold off. These managers were impacted when growth styles started to recover more quickly. Lonsec notes, however, that those managers with value biases have bounced back (in some cases sharply) as the value rotation has taken hold since late 2020, though Lonsec notes it is too early to suggest how sustained this will be and may be somewhat dependent on the path of the economic recovery from here.

Lonsec believes articulation of the manager’s strategy to be important given it is likely to provide a greater understanding of how the manager and their fund is equipped to perform in different environments. Nonetheless, it is important to recognise that Lonsec’s ratings encompass a ‘through the cycle’ view on managers we assess.

Figure 5

Key takeaways

Whilst portfolios may be diversified at the asset class level, this may not be indicative of the inherent level of diversification overall within portfolios. As Lonsec has seen in its recent multi-asset review, biases towards the value factor have, in some cases, been high and exacerbated by biases coming from both asset allocation and security selection effects. Lonsec prefers to see diversification across not only style, but also strategy, geography, sector and factor. Value biases have been pronounced in some portfolios in recent years given high valuations and the belief in some quarters that the cycle was maturing. This positioning has proved a performance headwind against passively managed SAA weighted benchmarks in recent years and in recent months led to significant performance dispersion among different strategies.

Going forward, while it is difficult to time decisions over shorter periods, Lonsec expects greater levels of dispersion in markets which should provide greater opportunities for active asset allocators to extract alpha from markets. Lonsec continues to discuss the foundations for any active bets in portfolios and the framework behind such decisions. Moderately leaning into certain style or factor bets can be challenging but possible at points in the cycle when supported by a strong asset allocation framework.

When the value bias in an investment manager’s approach is compounded in the security selection process, Lonsec believes asset allocators must be cognisant of the degree of value bias in their portfolios to ensure this is in line with their strategy (or any factors for that matter). All bets must be intended with unexpected performance resulting for those unaware of their true exposures. As valuations have been shown to have stronger explanatory power on returns over longer term horizons, Lonsec also continues to progress conversations on the time horizon of manager’s decision making processes. Overall, Lonsec believes that asset allocators making shorter to medium term decisions should include value as one factor among others that may have increased forecasting power over the medium term.

Authors

Darrell Clark, Manager, Multi-Asset

Sebastian Lander, Senior Investment Analyst

Issued by Lonsec Research Pty Ltd ABN 11 151 658 561 AFSL 421 445 (Lonsec). Warning: Past performance is not a reliable indicator of future performance. Any advice is General Advice without considering the objectives, financial situation and needs of any person. Before making a decision read the PDS and consider your financial circumstances or seek personal advice. Disclaimer: Lonsec gives no warranty of accuracy or completeness of information in this document, which is compiled from information from public and third-party sources. Opinions are reasonably held by Lonsec at compilation. Lonsec assumes no obligation to update this document after publication. Except for liability which can’t be excluded, Lonsec, its directors, officers, employees and agents disclaim all liability for any error, inaccuracy, misstatement or omission, or any loss suffered through relying on the document or any information. ©2021 Lonsec. All rights reserved. This report may also contain third party material that is subject to copyright. To the extent that copyright subsists in a third party it remains with the original owner and permission may be required to reuse the material. Any unauthorised reproduction of this information is prohibited. 

The Australian equity market experienced another positive quarter of performance to the end of March, delivering a 4.1% return as measured by the S&P/ASX 300 Accumulation Index. The recent gains have contributed to a significant 38.3% return over the past 12 months, when the local market touched its cycle lows on 23 of March 2020.

The quarterly return was led by the telecommunications, financials and consumer discretionary sectors, with key companies producing stronger than expected results primarily driven by cost control and margin expansion. The banks reinstated larger dividend payouts and material writebacks of their COVID-related bad debt provisions, signaling to investors increased confidence in their earnings outlook. Long-term bond yields were up 77 basis points in response to stronger economic activity flowing through to a re-pricing of higher inflation expectations. In this environment, banks should benefit with improved earnings growth. Very low levels of community transmission and the rollout of the COVID-19 vaccine program have delivered a boost of optimism for investors, particularly sectors directly linked to the re-opening of the economy, in particular consumer discretionary, industrial and resources. A cautionary note: companies that have benefited from COVID-19 (e.g. Coles and JB Hi-Fi) will have significantly higher comparable sales to meet or exceed in upcoming result periods to maintain their share price gains.

The telecommunication sector gained 13.9% courtesy of merger and acquisition activity with Macquarie Infrastructure Group and Aware Super launching an indicative bid for Vocus, and further details on Telstra’s proposal to restructure its business model. Telstra’s restructure would split the company into four business segments, seeking to realise the value of the company’s infrastructure assets, which the market has responded to positively with some brokers upgrading their target prices.

Resources maintained their positive momentum with the global economic recovery continuing to gather pace. Miners including BHP (+9.6%) were driven by a resilient iron ore price and announcements of larger dividends at their recent February results. Within the Energy sector, Santos (+14.2%) and Oil Search (+10.7%) were also stronger performers as the Brent Crude price increased to US$64 per barrel.

S&P/ASX 300 TR Index three-year rolling returns (% p.a.) to 31 March 2021

SOURCE: LONSEC, FINANCIAL EXPRESS

The value rotation has been in full swing since October 2020

SOURCE: ABS

Australian share index performance to 31 March 2021

SOURCE: FINANCIAL EXPRESS

Information Technology was the laggard sector delivering -10% in the March quarter, with several companies not matching their high expectations (e.g. Appen in the recent results period). Investors are pivoting away from COVID beneficiary sectors IT and Healthcare, while shifting investor attention to cyclically exposed stocks and higher bond yields detract from the value of their long-term cash flows.

Value outperformed growth by 9.6% in the March quarter

The rotation out of growth into value sectors continued over the March quarter with the economic recovery starting to materialise with a lower unemployment rate contributing to stronger growth. Unless some unforeseen tail risk event occurs, it is expected that business and consumer confidence will rise, providing a clear indication of ‘normal’ conditions returning in the not-too-distant future.

The small cap segment of the market experienced a softer return outcome in the March quarter compared to its broad-cap counterparts returning 2.1% as measured by the S&P/ASX Small Ordinaries Index, with mixed performances from the small resources index delivering -2.8% and the small industrials index gained 3.3%.

The Australian equity market is trading on a one-year P/E ratio of nearly 20 times, which is circa 30% above the long-term average of 14.5 times and prima facie looks stretched relative to history. However, based on the current environment, with policy and liquidity support underwriting economic activity for the foreseeable future, the market appears to be moderately expensive.

Outlook

Presently, the Australian equity market is profoundly influenced by macro factors surrounding the management of Covid-19, with company specific fundamentals taking some form of a back seat. The unprecedented fiscal and monetary stimulus measures implemented over the past 12 months should continue over the medium term but gradually taper off on the basis that Covid-19 is well contained, and economic re-opening becomes a sustainable state of affairs.

While it is not expected to be smooth sailing, as the economy moves towards a solid recovery phase, the reflation trade is likely to occur with cyclicals benefitting on relative basis over long-duration growth companies.

Issued by Lonsec Research Pty Ltd ABN 11 151 658 561 AFSL 421 445 (Lonsec). Warning: Past performance is not a reliable indicator of future performance. Any advice is General Advice without considering the objectives, financial situation and needs of any person. Before making a decision read the PDS and consider your financial circumstances or seek personal advice. Disclaimer: Lonsec gives no warranty of accuracy or completeness of information in this document, which is compiled from information from public and third-party sources. Opinions are reasonably held by Lonsec at compilation. Lonsec assumes no obligation to update this document after publication. Except for liability which can’t be excluded, Lonsec, its directors, officers, employees and agents disclaim all liability for any error, inaccuracy, misstatement or omission, or any loss suffered through relying on the document or any information. ©2021 Lonsec. All rights reserved. This report may also contain third party material that is subject to copyright. To the extent that copyright subsists in a third party it remains with the original owner and permission may be required to reuse the material. Any unauthorised reproduction of this information is prohibited. 

Debate in global property markets is now focused on office markets and how the global pandemic may have changed demand for office space on a permanent basis. In Australia, the immediate impact has seen CBD office vacancy levels rise in Sydney and Melbourne from 3.0–4.0% to around 8.0–9.0% over the year to January 2021.

Net absorption for Australia overall has reduced from +50,000 sqm in the six months to January 2020 to -90,000 sqm in the latest six months to January 2021. Sub-leasing levels have spiked as tenants with longer leases look to offload spare capacity. While face rents have remained largely unchanged, incentives have jumped to over 35% compared to around 25% pre-pandemic, dampening net effective rents.

The return to work in CBDs is progressive, but there is a growing realisation that more flexibility to allow working from home arrangements is both possible and desired. As corporates plan ahead and leases come to an end, already there is demand for core space plus an option for a flexible amount. Landlords will also need to ensure that buildings provide good quality space (including high environmental ratings) with facilities being upgraded in line with social distancing requirements.

While there will be some requirement for more space per person, it is likely that the trend for more flexible space and working from home arrangements will drag on demand while the world works its way through this pandemic. Given there is the possibility of more pandemics in the future, the outlook for office space will have a higher degree of uncertainty. A bright spot is medical and life sciences office space, where demand has been boosted by pandemic conditions.

Property sector will keep evolving

In the March quarter 2021 Australian property securities lost ground (S&P/ASX 300 A-REIT Index -0.5%) to the broader Australian equities index (+4.3%), although a stronger March almost made up for a poor first two months of the new year. Conversely, global property securities – AUD hedged (+7.3%) outperformed global equities – AUD hedged (+6.1%) during the first quarter of 2021.

Healthcare property continues to evolve with limited listed opportunities in Australia but increasing activity in unlisted funds. The highlight during the last quarter was the bid for Australian Unity Healthcare Property Trust by Canadian-based NorthWest Healthcare, with two conditional bids being rejected by Australian Unity as significantly undervaluing the patiently accumulated portfolio (December 2020 value was $2.4 billion) plus the ongoing development potential.

Heavily sold off early in 2020, retail property REITs have had bursts of recovery during the last six months as investors reacted to a vaccine-led recovery. Food and necessity-based shopping centres have continued to trade well and remain in demand by investors. Shopping strips and malls with a high proportion of discretionary spending have been hard hit, and owners face a period of readjustment in tenant mix and rentals. Nevertheless, in countries where lockdowns have lifted, foot traffic has rapidly returned to the ‘fortress’ shopping centres.

Secondary market for residential property expected to stabilise

A surprising area of strength is the residential market in Australia and some other parts of the globe where the COVID-19 response has been well handled (e.g. New Zealand). The combination of the RBA announcing that interest rates would stay low for a number of years and a shortage of supply in the secondary market has seen prices escalate quickly. This seems at odds with the underlying economic conditions in Australia where government income support (i.e. JobKeeper) has now ended and banks require mortgages to be serviced after a brief hiatus for those in need.

Lonsec expects some stabilisation to occur in pricing for the secondary housing market as these factors take hold and supply increases. Developers of primary housing stock will reap the benefits in the near term, although the apartment market is softer as demand is weak (no international buyers or renters) and rentals are about 20% lower than the pre-pandemic level. While values in regional and coastal areas have reacted to the work from home trend, this is also a reflection of relative value compared to the capital cities.

The residential rental and manufactured housing sectors are well developed internationally and have shown their resilience with a high proportion of recurring income from a multitude of tenants, although these sectors are not immune from some impact of a pandemic. Student housing is a good example, where travel restrictions have seen international student occupancy at very low levels. Longer-term trends of demand for high quality education should see these businesses recover in due course.

Property subsector winners include the Industrial and logistics and data centre sectors as growth continues off the back of accelerating trends towards e-commerce. However, pricing of assets in this area has become historically expensive and investors need to tread carefully to ensure the properties have tenants that are tied in not only by long leases, but by specialised fit-outs (preferably tenant funded). Similarly, hotels and lodging earnings are set to benefit as intra-national travel restrictions are eased and are dependent on how international travel patterns pan out.

A key positive that remains in place is low interest rates globally, which are having the impact of maintaining investor demand and underpinning tight market capitalisation rates (apart from discretionary retail assets). Lonsec maintains the view that these policy settings are artificially low, and as inflation resurfaces, bond rates and borrowing costs will rise (the US 10-year rate rose from 0.72% in October 2020 to 1.85% at the end of March 2021).

At this stage, REITs remain reasonably geared and investors should steer away from companies starting to push these boundaries. At the same time, highly priced property groups with components of funds management and development earnings can be vulnerable to a reversal of asset values.

Issued by Lonsec Research Pty Ltd ABN 11 151 658 561 AFSL 421 445 (Lonsec). Warning: Past performance is not a reliable indicator of future performance. Any advice is General Advice without considering the objectives, financial situation and needs of any person. Before making a decision read the PDS and consider your financial circumstances or seek personal advice. Disclaimer: Lonsec gives no warranty of accuracy or completeness of information in this document, which is compiled from information from public and third-party sources. Opinions are reasonably held by Lonsec at compilation. Lonsec assumes no obligation to update this document after publication. Except for liability which can’t be excluded, Lonsec, its directors, officers, employees and agents disclaim all liability for any error, inaccuracy, misstatement or omission, or any loss suffered through relying on the document or any information. ©2021 Lonsec. All rights reserved. This report may also contain third party material that is subject to copyright. To the extent that copyright subsists in a third party it remains with the original owner and permission may be required to reuse the material. Any unauthorised reproduction of this information is prohibited. 

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