Making a virtue out of necessity
While investors have grown weary of new risks, they are unwilling to forego a bargain when they see it, according to Jim McCaughan and Amin Rajan
Since the Lehman collapse in 2008, equity markets have been unusually erratic. Asset classes have moved in lock-step. Price-earnings ratios have lacked sensible anchor points. Fear, greed and stress have amplified market cycles.
The debt crisis in the West is the prime cause. Tackling it will be a long haul, fraught with policy errors, social unrest and political expediency. Politics, more than economics, will likely drive the markets during this decade. But times of high risk are also times of big opportunities, according to the latest Principal Global Investors/CREATE annual survey*.
It shows that 78% of our respondents believe that markets are now in an era of prolonged turbulence; and 19% think prolonged turbulence is possible. Hence, over 60% expect two or more systemic crises before the decade is out. As ever, the definition of crisis is subjective, and few believe that the worst is over.
The reason is obvious: the mother of all debt bubbles in the West is being deflated against a disorderly political background. Policy attempts have reshuffled the debt, not reduced it. Far from an early resolution, there are signs of going back on key reforms. But there are other reasons, too.
The latest financial regulation is fraught with unintended consequences. The Dodd Frank Act in the US and Solvency II in Europe will perversely turn banks and insurance companies into forced sellers of securities in times of distress. The Volcker rule risks the worst of both worlds: reduced market liquidity and distorted price discovery.
Aided by technology and the 24-hour news cycle, growing globalisation of markets will amplify investor mood swings and compress their decision spans from calendar time to real time. High frequency trading (HFT) will be a further reason. By ‘front running’, HFT will continue to accelerate the directional velocity.
In summary, fear will continue to obscure the fundamentals. Historic parameters and investment assumptions will remain suspended while it lasts. Price anomalies will be rife.
Having weathered many rollercoaster rides since the bear market of 2000, there is as much concern about missing the next rally as about being caught by its untimely demise.
Fight or flight not the only choice
The regular headlines on risk-on/risk-off trades imply that investors only make binary choices as markets fluctuate. This is too simplistic, according to our survey. Since 2008, end-investors have been responding differently to the crisis:
• 5% have been ‘adventurists’ who believe in contrarian investing and market timing amid turmoil;
• 35% have been ‘pragmatists’ who believe in portfolio re-balancing when momentum is working;
• 40% have been ‘purists’ who believe in buy-and-hold investing and see volatility as a futile game;
• 20% have been ‘pessimists’ who lost a bundle in the last decade and cannot wait to exit at an opportune moment.
Such behavioural differences show that fight or flight will not be the only choice. It can also be both or neither. Investors will blend both within a bigger permutation. Within individual investor segments, re-risking will prevail alongside de-risking. If caution is the new watchword, opportunism is the new interest. The greed-fear cycle will be lurking in the background.
More generally, defined benefit (DB) clients are more likely to de-risk; while defined contribution (DC) clients and retail clients are more likely to de-risk as well as re-risk. Value investing will retain its hypnotic appeal but it will be tempered by value traps from periodic dislocations.
Notably, in the face of acute funding gaps, DB clients will resort to one or more of three options. Firstly, a small minority will dial up the risk by venturing further out on the risk frontier via higher yielding assets. Secondly, the majority will chase the investors’ equivalent of the Holy Grail: getting additional alpha without taking on further beta risks. Via periodic portfolio re-balancing, some will aim to use fundamental indices to create ‘smart betas’ that deliver cheap alpha at no extra risk. Thirdly, some will squeeze costs to get existing returns at a reduced fee.
In any event, de-risking in the DB space will rely on liability-driven investing (LDI) as well as a new form of diversification that is far removed from the traditional asset-based approach that has long relied on historical assumptions of risk premia and correlations. It reflects a risk-minimising mindset more than return-enhancing mindset. One is holistic, the other siloed.
In the DB space, investors are likely to tilt towards equities in their medium-term asset allocation. They are seen at their most attractive relative to bonds in 50 years. Volatility has driven out swathes of panic sellers since 2008, creating conditions for a generational bull market. Emerging market equities are also likely to benefit from the projected tilt. Many clients see them as an opportunistic play via low-cost exchange-traded funds (ETFs).
However, the bulk of their opportunism will occur in distressed debt, high yield bonds and the ‘secondaries’ in real estate, private equity, commercial mortgages, collateralised loan obligations and senior debt. New opportunities will gain traction, as banks in the West withdraw from these areas to beef up their capital base by $3.5trn (€2.8trn) under Basel III.
In the DC space, plans that are managed by trustees will aim to de-risk their portfolios while investing in structures that permit re-risking when required. Those that are managed by individual members will rely on glide-path mechanisms to do automatic re-risking and de-risking in the face of random market swings.
In the retail space clients are expected to err on the side of caution, on the whole, with brief bouts of opportunism. There will be a clear divide between the West and the East. Those in the West will remain over-cautious in the wake of past losses and impending retirement. Those in the East will continue to be momentum-driven.
The strong rally in the first quarter of 2012 was subsequently overshadowed by the latest banking crisis in Spain. The debt overhang in the West is so big that deleveraging will take the rest of this decade.
However, while markets have been yo-yoing, corporate balance sheets worldwide have been unusually strong. Many companies have hoarded cash, paid down debt, done buy backs and locked into low interest rates.
In the US, the industrial bellwethers have reported record profits. The US has outpaced Europe in deleveraging since the start of this ‘balance sheet’ recession sparked by the trans-Atlantic sovereign debt crisis. The fears of a ‘hard landing’ in China are also receding.
No wonder, the Dow flirted with its pre-recession levels at the start of 2012. As in early 2009, a big wall of money is parked on the sidelines waiting for the green light. Unlike 2008, this is a confidence crisis, not a liquidity crisis.
Hence, 71% of our respondents believe that continuing volatility will offer a great opportunity to active managers to deliver good returns to their end-clients; a further 22% see this as a possibility. Yet only 13% believe that they can capitalise on it; a further 54% see this as a possibility.
The reported gap is indicative of certain hurdles that need to be overcome. These are covered below. In any event, there is no clear consensus on how the markets will evolve in the light of the exceptional rally in early 2012 because:
• 35% of our survey respondents detect positive straws in the wind while recognising the inflationary headwinds in the global economy;
• 40% remain undecided. They do not rule out the possibility that markets may revert to their historical long-term state where politics matter more than economics - as happened before the long bull market that started in 1985. Yet, they do not rule out a continuing recovery in the US that could act as a locomotive for Europe;
• 25% hold a pessimistic view. They envisage no clear directional shifts in the markets, as further quantitative easing merely piles up the current ‘cash mountains’ in the West.
Yet, one thing is clear: investors are as concerned about missing the next rally as about being caught by its untimely demise. It is reinforced by the widespread belief that successive bouts of volatility since the 2008 credit crunch have severely distorted market valuations.
Critical success factors
Over the past decade, as asset management has morphed into a mass market industry, it has become too industrialised. In the process, it has lost much of the craft heritage that was so conducive to riding the volatility waves in the past.
The unintended outcome has been that external and internal factors have reinforced one another to create a high degree of disintermediation and skewed incentives. After the ‘lost decade’, there is a lumpy legacy of mistrust.
The key factors external to individual asset managers are: clients’ behavioural biases, their risk aversion, and (with institutional clients) their restrictive policy guidelines. These have been reinforced by the mediocre track record of active management.
The key factors that are internal to individual asset managers include: lack of a credible track record on volatility trading, lack of tactical asset allocation capabilities, the entrenched buy-and-hold mentality and the adherence to style box investing.
To break this cycle, three mutually-reinforcing changes are essential: improved capabilities focused on price dislocations and high conviction investing; better client engagement focused on understanding their needs and avoidance of unrealistic claims about returns; and better alignment of interest focused on more symmetrical incentives.
The required improvements underpin two imperatives. Firstly, alpha is in the eye of the beholder. Investors are increasingly drawing a distinction between product alpha and solutions alpha: one is about beating the markets, the other about meeting their identified needs — like consistency of returns or customised benchmarks. For both types of alpha, greater proximity to clients is essential in setting and managing expectations.
Secondly, as part of greater engagement, investment professionals must also put their money where their mouths are. The asymmetric rewards inspire neither trust nor motivation, after millions of clients have lost billions of dollars.
Whereas industrialisation is irreversible, it does not preclude progress in these two areas to restore the best features of its craft heritage that are better suited to converting market ructions into investment opportunity.
Jim McCaughan is CEO of Principal Global Investors and Amin Rajan is CEO of CREATE-Research
*Available from www.create-research.co.uk