You can't ride the highs without experiencing the lows
Following market declines this month, investors paying heed to media may have thought the sky was falling. In fact, it was no time to panic, as these declines only took us back to where we were in May. Simon Doyle discusses asymmetry in investor attitudes towards risk and why there will come a time when it will be important to be different.
I’ve been struck down with a bug and have spent the last few days at home. Daytime TV is a bit of a new experience and what I didn’t know is how many forms of funeral insurance there are and how important it is for me. No – I didn’t buy any – but I am thinking about it. I also got to see the news bulletins and accompanying dramatic music as “billions was lost from YOUR superannuation” as markets declined on the back of, among other things the escalating US/China trade tensions.
The importance of perspective
There were several things that struck me about this. Firstly, that these headlines failed to put the early August market declines into any context. The sky may have started to fall in August, but this was following a 23% gain in the seven months prior; and in any case, the decline only really took the market back to where it was in May. I’d hardly call this time to panic.
Secondly, it reminded me of the asymmetry in the generalised attitude of investors to risk. We want the upside, and not the downside – even if we think we have a more symmetric risk tolerance.
Thirdly, it highlighted to me how unprepared most people are to a major shake out in markets. We’ve bought the idea that the re-engagement of central banks will save the day, and this has progressively squeezed out most of the risk premium we would typically require to hold risky assets – there is no risk, right, if the Fed and other central banks continue to inject liquidity?
Consistent with this latter point is the idea that the giant Ponzi scheme that central banks are creating is becoming so systemically important that it can’t seemingly be allowed to fail. Any market weakness is met with policy response, so markets are increasingly driving policy – and so the circle continues.
Last month I wrote about the “recency effect”. A few clients did tell me they had to look it up and yes, it is a documented phenomenon. A practical illustration of this is the “pull to peer” trend among the institutional market. The bull market in “everything” has rewarded investors in typical SAA/equity heavy strategies, opening up a gap between funds that have adopted more objective-based approaches and those that have structurally ridden the central bankinduced bull market. While the latter have done well against their long-run objectives, the pressure to be at the top of the peer group is strong. Being different is a risk.
The realities of the current political, regulatory, and business environment make this easy to understand. It’s less easy to rationalise from an investment standpoint. This model holds together while markets do. However, as 2018 reminded us (even if it has since been quickly forgotten), environments do change. While it can be costly to bet against central banks, it is an equally big call to buy the idea that central banks are infallible. If the template that has worked so well in recent years does come under pressure, the news headlines on the “billions lost” will make for hard listening. There will come a time when being different will be very important.
The Real Return Fund
The Real Return strategy was not designed as a peer-relative strategy, albeit ex post, peer comparisons can and will be made. It was designed to target a particular rate of return and to do so in as consistent a manner possible. It is not designed to track equity markets but rather participate in the upside as a source of return, but to minimise the downside (consistent with a belief in the asymmetry of investor risk tolerances) and the fact that sequencing risk is important.
In the current context, we hold a moderate amount of equity exposure – similar to the level we held in the middle of 2018 – meaning we are reasonably defensively positioned in terms of overall exposure to risk assets. The biggest change to positioning in July was to close the Short A-Reit/Long ASX 200 trade in the portfolio. This was a trade that we have held for some time. It was based on the idea that A-Reits were expensive relative to the broader market (a view we still hold) and that, given the sensitivity of A-Reits to inflation and bond yields, should inflation surprise on the upside then this trade would provide a good hedge. However, with cyclical risks to growth intensifying and
central banks globally (including the RBA) now back on an easing track, the likelihood of AReits underperforming the broader market would seem to have lessened. In cutting this position we have also effectively increased portfolio duration. We also pared back the risk on our cross market Long Japan/Short US equity trade on the basis that with the Fed re-engaging it was harder to make the case for Japan to outperform the US (notwithstanding valuations still support a small position).
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