Winners & Losers

2015 has clearly been a more difficult year for investors. This is true for those focused on delivering “absolute” returns – like us in the Real Return strategy, and equally, if not more challenging for those focused on benchmark relative performance.

A key differentiator this year when compared to 2013 and 2014 has been the growing bifurcation between the winning and losing assets. While 2013 could be broadly categorised as a year where most assets did well, 2014 was somewhat more discriminating but on balance a good year for most investors. In 2015 (so far anyway), the winners have been an increasingly narrow set of markets with the common theme of being either directly or indirectly supported by low interest rates and interventionist central bank policies i.e. Japanese and European equities, a handful of growth and momentum stocks (i.e. US tech stocks), financially leveraged yield plays (i.e. REIT’s), and the US dollar. The losers have been anything linked to commodities (AUD, Australian equities, UK equities, resource and energy stocks and corporate bonds), and / or a stronger USD (i.e. emerging markets). 

A critical element of our investment approach is that valuations matter – particularly with respect to medium / longer term returns, and importantly risk. What’s increasingly evident with respect to the winners and losers of 2015 has been the abject disregard for value, together with the increased importance seemingly given to momentum. In other words, investors are continuing to buy “yesterday’s winners”, rather than focussing on what’s more likely to deliver going forward. In this context it’s easy to argue that the winning strategies of 2015 are increasingly high risk – especially if losing money over the medium term matters. This is equally true in the context of the Australian equity market where investors have continued to shed risk in the resource and energy sectors, preferring the relative safety of banks and other financials (like A-REIT’s).

There are several implications of this from the portfolio’s perspective.

Firstly, while we have captured some of these themes, we have not been prepared to invest client capital to what in our view are a series of high risk, momentum driven trades. There has been an opportunity cost to this approach as we haven’t had exposure to some of the better performers (both at an asset allocation and stock selection level). That said, this opportunity cost has only been in terms of returns. Risk in the portfolio has remained low and has not been compromised as it would have had if we pursued some of these themes.

Secondly, in an environment where the “free kick” from relatively attractive valuations and direct central bank support are coming to an end, managing potential downside risk and ensuring ample liquidity to capture the opportunities presented by an apparent increase in market volatility has been paramount. 

Thirdly, the current environment clearly presents a challenge going forward as overall return expectations remain low reflecting challenging starting point valuations and mixed fundamentals. Consistent with the idea that valuations matter (and with our natural contrarian temperaments), we continue to favour the markets that dominate the losers list above (like Australian equities) mainly because they’ve already priced considerable bad news. That’s not to say there couldn’t be more downside to come – but for some markets (like US equities) investors have yet to reflect the challenges of potentially higher rates and a moderating profit environment.  

Finally – we are increasingly asked as to whether our CPI +5% return target is too demanding and should be reviewed in light of the challenging return outlook. The answer to this question is no. It is true that “starting from here” it will be more difficult than it was 3 years ago and that timeframes will be important (our objective after all is CPI+5% p.a. over rolling 3 year periods – not 5% p.a. over each and every rolling 12 month timeframe – an important distinction).  In contrast to the last 3 years though we expect to be more active as volatility picks up and cash is both deployed and withdrawn in the process of markets adjusting. We also expect a greater contribution from security selection as the themes that have challenged our actively managed strategies reverse, along with continued contributions from the realignment of currencies and interest rates.

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