Onwards and upwards

Onwards and upwards

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With governments and corporates nervous and debt-laden, and interest rates low, the assumption has been for some time that investors must resign themselves to lower equity returns. 

This is a low-growth world, in which companies struggle to grow earnings and deflation is a greater threat than inflation. This belief has shaped innovation in the investment management industry for much of the past decade.

The reality has been somewhat different. Equity returns have been relatively strong over the past five years, notwithstanding recent volatility. 

Nevertheless, with valuations high and economic growth low, it is difficult to see how equity markets can surge forward from here. As such, some of the options created by the fund management industry to tackle the problem of structurally lower returns may now start to bear fruit.

One initiative from the fund industry has been a renewed push-back from active managers against the prevailing trend for passive products. If equity markets are weak in aggregate, so the logic goes, a more nuanced approach with a focus on alpha rather than beta is a more appropriate way to invest.

Some fund groups have launched a series of more concentrated, stock-picking portfolios in line with this principle. 

“GDP growth is lower around the world,but it is possible to find stocks experiencing secular growth, though those opportunities are scarcer than they were. This argues for a benchmark-agnostic approach in terms of selecting stocks,” says Colin Dryburgh, co-manager of the Kames Diversified Growth fund.

This has been invigorated recent years as many large cap stocks have struggled; financial and resources stocks have been particularly weak. Dryburgh adds: “It has been necessary to look beyond these large cap stocks to find opportunities.

The poor performance has been significantly impacted by sector performance – the banks have done badly for various reasons, as have commodities.”

Coming up short

The natural extension to this has been the expansion of the long/short equity market. A loosening of the UCITS rules has allowed more investors to access hedge fund-like strategies within a more tightly regulated structure.

The focus on alpha over beta and a lack of correlation to traditional equity markets argues for long/short funds in a low return world.

However, not all have lived up to their billing. Returns have looked relatively lacklustre compared to buoyant equity markets. Likewise, some of those that didn’t trail the equity markets rebound were stuffed with equity market beta so did not provide the uncorrelated returns that investors sought. Either way, investors have not received quite what they expected.

James Klempster, head of portfolio management at Momentum GIM, says: “The record of long/short equity is slightly patchy. There are so many strategies within the different categories. There are a few good ones and a lot of not-so-good ones. The key has been to not buy equity market beta dressed up as non-correlated returns. Investors would be paying a lot of money for it.”

Richard Philbin, chief investment officer at Harwood Multi-Manager, says: “Part of the problem is that many people didn’t understand what they were buying.”

Also within the absolute return camp falls multiasset strategies. Multi-asset is a broad church, but generally involves harnessing a variety of risk drivers within one portfolio. Most have an absolute – LIBOR or inflation-linked – benchmark and aim for lower volatility than traditional equity markets. The notable success story has been the Standard Life Global Absolute Return Strategies fund (GARS), which now has around £27bn in AuM.

Rory McPherson, head of investment strategy at Psigma, says that this type of strategy has more appeal as a source of diversifying returns: “Lots of absolute return funds have ended up having a lot of equity beta. We don’t use them as much. We likefunds such as BNY Absolute Insight fund, which have very low volatility, employ stop losses and have low correlation to equity markets. We want funds that can deliver absolute returns across all markets cycles.”

He says that a lot of absolute return strategies have also had a “credit tailwind”. While this has been positive to date, some valuations in Europe now looking very extended, with around 15% of the European credit market trading with a negative yield.

A white paper by Credit Suisse gives a more generous verdict on these alternative UCITS funds: “It seems that alternative UCITS funds exhibit lower volatility on average than offshore hedge funds but tend to provide similar risk return characteristics. Also, whether offshore funds outperform alternative UCITS funds seems to depend on the investment strategy.”

Liquid alternatives 

Avoiding correlation has also become a particular focus for investors. The global financial crisis brought about a new understanding of the extent to which asset classes could correlate at times of market dislocation.

For some time, government bonds seemed to be the only genuinely uncorrelated option for an equity portfolio.

However, the search has led investors to place a greater emphasis on alternative asset classes. Notably, liquid alternatives, hedge funds that can be traded daily, have seen a rise in popularity. Groups such as Schroders, BlackRock and Threadneedle have sought to organise disparate alternative strategies into a coherent offering, providing investors with varied sources of risk.

“There are two main camps that have sought out alternative beta,” says Benjamin Simonds, client portfolio manager on the alternative beta funds at Columbia Threadneedle Investments. 

“The first are large investors who have only invested in hedge funds and no longer want to pay the high fees, but still want non-correlated assets. The second is for those that want to invest in hedge funds, but have constraints – it gives them a less volatile return profile. It is more cost-effective and liquid.”

He says that this is the early stages of adoption by institutional investors. European investors are showing a lot of interest. South African and Australian investors have also shown an interest, alongside some of the larger US institutional investors such as CalPERS. 

To some extent, hedge funds have been the casualty, though this may have as much to do with a more forensic focus on fees, or capacity constraints.

The growth of liquid alternatives is set to continue, according to a recent McKinsey report: “The vast majority of institutional investors intend to either maintain or increase their allocations to alternatives over the next three years. Interest is especially keen among large and small pension funds (though not midsize funds) and sovereign-wealth funds. 

Wealthy individuals are also moving rapidly into the market, as new product vehicles provide unprecedented access to retail investors. Flows from each of these four groups could grow by more than 10% annually over the next five years.”

Smart beta

Smart beta can also, to some extent, fall into the liquid alternatives category. Smart beta means different things at different investment houses, but generally involves slicing the market to harness idiosyncratic risk areas. 

Smart beta has been one of the strongest areas of growth in recent years. The most recent Lyxor ETF Barometer shows that flows into European Smart Beta ETFs were €2bn in the first quarter of 2016. Total assets under management are up 4% over the end of 2015, reaching €16.7bn. Smart beta assets have doubled since the end of 2014.

Smart beta products aim to address the criticisms of a market capitalisation weighted indices – the skew to certain sectors of the economy and an overweight bias to yesterday’s winners – while retaining some of the advantages of passive investment such as diversification, liquidity, transparency and lower cost.

“Seemingly some inefficiencies can be identified quantitatively that are not being arbitraged away – value/growth, size, quality, momentum and so on,” says Klempster. The concept is now being refined and extended; the Threadneedle alternative beta group, for example, do not just invest in the top 20% of a factor (such as value or momentum), but also short the bottom 20%. 

Nevertheless, the sector has come in for some criticism, notably from Rob Arnott, the founder and chairman of Research Affiliates, the US company that developed some of the world’s first smart-beta indices. 

He was recently quoted as saying that many of the underlying ideas behind many new smart beta strategies are “nonsense” and would leave investors nursing large losses. For some, the emphasis on factors is not the best way to slice markets. McPherson says: “We prefer to overweight sectors and themes than risk factors.” 

Others have criticised the sector for its higher costs, compared to market-capbased ETFs. There has also been a multitude of new asset types. Dryburgh highlights the increased diversity in the closed-ended world in areas such as renewable energy, aircraft leasing and infrastructure. There are also new growth areas within fixed income: “Some parts of the high yield market are offering high spreads and should have a lower risk than equities” he says. It’s the economy… 

Few see a rapid end to the prevailing low-growth environment. Klempster says: “Equity markets have been sustained by earnings growth and multiple expansion, but that has petered out somewhat. 

Earnings growth is keeping markets ticking over.” Ian Stewart, Deloitte’s chief economist in the UK, said in a recent blog: “The money-making properties of equities in the long term relate to their performance in the past. There is no certainty that history will repeat itself. In the familiar words of the warning that accompanies most retail investments, ‘past performance is not an indicator of future returns’.” 

Dryburgh says: “Low growth is a function of low inflation and low real GDP . There is too much debt relative to GDP and global debt is increasing. Taking on more debt tends to lead to lower growth. Also, demographics suggests that growth is likely to slow.” McPherson points out that inflationary pressures are re-emerging in the US, even thought it is still below the Federal Reserve’s target. 

He says: “Core inflation is above 2% and we are seeing wage pressures rising.” As such, he argues, portfolios need some protection against inflation. “It is not a good trade-off to own very expensive bonds. It is important to own equities that can either grow their earnings, or are very cheap.” In this context, all the usual rules apply; it is important to be selective and diversified. 

The most recent Lipper report into launches, liquidations and mergers in the European fund industry noted: “In the overall low interest rate environment, mixed and multi-asset products as well as alternative UCITS seem to be the preferred asset classes for European investors.” 

“Alternative UCITS already have seen high inflows over the past few years and are one of the top-selling asset types for the year so far… There is a lot of space for new products in this area, especially since a number of large promoters are not active in this space at the moment.” 

The other area of development is likely to be the expansion of passive offerings, both in smart beta, and into other asset classes such as bonds. Already a flourishing market in the US, this is likely to be replicated globally as investors’ focus on cost increases, at a time when it is likely to form an even greater chunk of overall returns. 


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