The Problem with Recovery!
As we sit here in sunny Northampton, reminiscing about the few days we have spent at the office in London, looking at another building, and now how beautiful it is to look out over the countryside, it is apparent from a technical perspective that all is not as clear as the view out of my window, in the world of asset allocation.
The reason for this discussion is that we are in an environment whereby some of the riskiest assets that we allocate to in our portfolios, being small cap equity, are actually displaying the smallest levels of volatility and adding the largest contribution to portfolio returns. In contrast nearly all non equity – assets being gilts and bonds of varying risk grade, which should be the cautious bedrock of a client’s portfolio, delivering an expected annualised contribution of circa 5%, have become toxic.
When we refer to gilt and corporate bond assets becoming toxic, we do not mean toxic in the same way that equity became Toxic in 2008, or property in late 2007. What we mean is that we no longer expect the asset classes to provide a positive contribution towards the overall outcome, the portfolio is designed to deliver, over the coming 12 to 24 months. Please see the chart below to see the total return, (price + yield) of the assets under observation since May 2013 to date.
Total Return Bid-Bid line chart (from 01 May 2013 to 21 Nov 2013) from UK UT and OEICs universe. Rebased in Pounds Sterling – please click on chart to view full screen
The lack of any absolute return in real terms on these assets over the period is in our opinion expected to continue as we transition into and through the era of reduced quantitative easing and development in the economic cycles from recession to recovery and into expansion. In English that means we expect yields on all debt to increase and on that basis the price will fall in varying degrees, with no capital uplift being given. This is due to reduced default risk on the risker assets, as this is already low. That scenario will continue until we are mid-way through the economic cycle development and we believe that is at least two years away and maybe further depending on how the economics and populous cope as interest rates start to rise.
This therefore makes the on-going development of a multi asset strategy for the more cautious clients; that would not normally associate themselves with being invested in small cap funds harder and harder to manage. It is important therefore that we continue to discuss and educate our clients and stress test all decisions, and not blindly follow an asset allocation strategy forced on us by history. Especially when we are about to enter the positive end of the deepest financial and balance sheet led recession for over 80 years, against which we have no data against which to assess how these assets will perform. This current scenario and lack of constructive data, also further destroys the long hold theory, with periodic rebalancing to a fixed asset allocation; the logic, of Modern Portfolio Theory. This is unless of course you accept that for the next two years you will make nothing in absolute terms.
If we look backwards, since March 2008 there is not a single individual in the UK that has not been touched by the financial crisis and as an asset manager during the intervening five and a half years we have had moments of significant triumph and days of reflection. Going forward from here though it is going to be the smart asset manager that has sleight of hand, total independence and will show skill and an ability to adapt which will add value. These combined skills are required to navigate the asset pool and pick selectively to be in the right asset at the right time and cyclically adjust the portfolio.
The risk takers under our Outcome Based Investment (OBI) strategy are again going to be rewarded over the coming few years. This is because with these, we take risk when we feel it is going to be rewarded and remove risk when not, so the flexibility of our mandate allows us to deliver the objectives and protect capital.
For the more cautious investor though, they could be punished through the recovery phase because being in cash gives nothing and being in gilts and bonds is also going to give nothing unless we short the yield, which we are doing. This shorting of the yield curve will only give moderate returns though and can only be done with a modest element (up to 20%) of the portfolio, but it will at least provide a positive contribution to the target outcome.
Other than shorting the yield, using strategic bond funds if selective, may give a positive return as will investing in property and some European high yield funds where default risk will still be reducing, as economic conditions improve Therefore the prices will rise and assist in the total return of those assets.
The problem therefore with a firm movement towards Recovery in the developed world’s underlying economies, is that the cautious investor who is most spooked by the calamitous falls periodically in equities, will lose again. This is because by nature a cautious investor is fearful of investing into what is perceived to be portfolio risk, by increasing the exposure to risky assets, because risk is being measured as a constant.
At OCM we measure risk both by looking backward but also and more importantly by looking at expected market momentum and volatility, against the current economic backdrop. In addition we look at our expectations of forward looking momentum based on a full fundamental analysis, every day. Therefore if we do not expect risky assets to be risky based on the fundamentals, we will allocate to them, but in such a way that we can reverse that decision if the fundamentals change.
Being satisfied with the idea that a fund has fallen by less than an index won’t help when other asset classes are also falling, and feeling confident to invest at the end of the rally is also just as bad. Please find detailed below the performance of our model portfolios at OCM Year to Date. If you have any questions please contact a member of the team directly
Total Return Bid-Bid line chart year to date (from 31 Dec 2012 to 20 Nov 2013) from UK UT and OEICs universe. Rebased in Pounds Sterling - please click on chart to view full screen