A different approach to asset allocation - how to perform in a low return environment
Issues to be addressed in this research paper
A very conventional asset allocation approach – and the one used by the vast majority of investors – is a classic top-down approach where, given a set of macro-economic expectations, decision makers determine which asset classes they want exposure to, and to what degree.
This is the New Normal, though, and not everything behaves like it used to do. One of the dynamics behaving fundamentally different in the New Normal is how risk assets correlate with each other. When risk is ‘on’, virtually all risk assets tend to rise, and when risk is ‘off’ they fall. Correlations between risk assets have therefore risen quite dramatically in the New Normal, making it more difficult to outperform, and outperformance is an absolute necessity in the low return environment we are in, assuming you want a decent return on your investments.
I have been thinking long and hard about this one. Is there any credible alternative to a classic top-down approach that we should consider? In other words:
Are there any inefficiencies in the New Normal that one can take advantage of which will drive returns higher and make a successful outcome more likely?
In this research paper I will simply assume that returns are going to be comparatively low for many years to come, and I won’t question whether that is a fair assumption or not. The emphasis will instead be on what investors can possibly do to achieve higher returns than one would (and should) expect, given those expectations.
The most obvious reason returns are low
Risk premium is defined as the long-term excess return on risk assets over the risk-free rate of return. The risk premium has varied over time and is not the same for all asset classes. To complicate matters further, when talking about the risk-free rate of return, some use yields at the very short end, whereas others use longer-dated government bond yields. However, for the sake of simplicity, when I talk about the risk premium in the following, I will be referring to equity risk premium. I will also assume that policy rates (e.g. the Fed funds rate) are akin to the risk-free rate of return.
On that basis, it would be fair to say that the risk premium over the past century has probably been around 4-5% on average. Consequently, one shouldn’t really be surprised that equity returns at the moment are quite subdued, and one shouldn’t be surprised at all, if that continues to be the case for as long as the risk-free rate of return remains close to 0%.
What not to do
U.S. corporate bond yields are still respectable – at least relative to government bond yields – and that is particularly true in the high yield space. Adding to that, there appears to be a widely held belief that corporate America (ex. the energy sector) is very cash rich, and one can therefore invest with only a modest amount of risk attached. In my view nothing could be further from the truth. Some numbers to back up that claim (Courtesy of The Credit Strategist, Standard & Poors and Moody’s, June 2016):
- The 1% most cash-rich of all U.S. companies control over 50% of all U.S. corporate cash.
- The five most cash-rich U.S. companies (Apple, Microsoft, Google, Cisco and Oracle) control 30% of all U.S. corporate cash.
- Total U.S. corporate debt (the other side of the balance sheet) was $5.03 trillion at the end of 2015, up from $2.62 trillion at the end of 2007.
- Net debt (i.e. debt ex. cash) amongst U.S. corporates was $3.39 trillion at the end of 2015 vs. $1.88 trillion at the end of 2007.
- U.S. corporate debt has risen by $2.8 trillion over the last five years, while corporate cash has only risen by $600 billion.
- If you back out the top 1% referred to in (1) above, the cash holdings of the remaining 99% fell 6% in 2015 to stand at just $900 billion by the end of December vs. $6.6 trillion of debt.
Based on those numbers, I think it is fair to say that, with the exception of a few extremely cash-rich companies, corporate America is increasingly indebted and not at all as cash-rich as widely perceived. This also explains why corporate investments in the U.S. are at a 60-year low. As investments today drive profitability and growth tomorrow, the low cash and the high debt levels reinforce my firmly held belief that GDP growth as well as equity returns will disappoint for quite a while to come.
Consequently, I am not at all comfortable with the solution chosen by many to invest in corporate high yield. Assuming inflation remains moderate in a low growth environment (and I am not even convinced about that), yields on investment grade corporate bonds are probably unlikely to move much; the real risk is to corporate high yield, where balance sheets, as alluded to above, are not nearly as robust as perceived.
What to do instead
Assuming you have followed ARP’s work for a while, you will know that we pay a great deal of attention to structural trends – trends that are non-cyclical in nature and that are bound to happen almost regardless. Some of the structural trends that we have identified may only have a modest impact on financial markets, whereas others are likely to have a massive impact, e.g. changing demographics. Our first recommendation is therefore to incorporate as many as those structural trends as possible in your investment strategy.
Since the financial crisis almost flattened the financial system back in the autumn of 2008, investors have had an extraordinary desire for liquidity, resulting in a significant illiquidity premium. Although that premium continues to fall, it is still meaningful, in particular if you are prepared to tie up your capital for 3-4 years or longer. Consequently, our second recommendation is to take as much advantage of the illiquidity premium as you can afford to liquidity-wise. In so doing, don’t be fooled by funds offering good liquidity, but where there is a liquidity mismatch on the underlying investment being made vs. the preferential liquidity offered to investors. Here investors are taking on illiquidity risk even though it is not apparent in the terms offered to investors.
In a low growth environment, and in particular when inflation is subdued, pricing power is critical. Pricing power is most easily achieved when your intellectual property is strong. Our third recommendation is therefore to seek investment opportunities associated with strong intellectual property. I should point out that investment opportunities with strong intellectual property can be found in traditional as well as alternative investment strategies.
As mentioned above, the financial crisis has left some remarkable scars in the investment landscape, driving the illiquidity premium to excessive heights. Another scar would be what I would call unusual behavioural activities. Because investors are so afraid of a repeat of 2008, they do things that are not always logical, which shrewd investors can take advantage of. An example would be an extraordinary level of herding. Herding has always existed, but it has certainly gained momentum as a phenomenon since 2008. Hence our recommendation no. four: Take advantage of behavioural opportunities. This can be something as simple as adding to your equity exposure when markets are very weak or, in the alternative space, it could be to invest more in CTAs, some of which have an excellent record of taking advantage of such opportunities.
Regulatory authorities are still busy cleaning up the mess created by the financial crisis, and will continue to be busy for many years to come. That said, total bank loans (in Europe in particular) are still very high, and regulators are keen to bring that number down. Consequently, more and more lending (away from retail lending) takes place outside the banking industry, and we certainly expect that trend to continue in the years to come. Ultimately, margins on alternative lending will almost certainly approach margins on traditional bank lending, but we are still far from that point, hence our recommendation no. five: Take advantage of regulatory opportunities in the financial industry.
Many larger fund managers (in both the traditional and alternative space) have delivered very disappointing results in recent years. Part of the reason behind the poor performance is undoubtedly the near zero risk-free rate of return, which is bound to hurt all investors. Another reason, I believe, is size (AuM). Following 2008, many investors concentrated their investments with fewer and larger managers. In principle, that was not a bad decision, but in practise it was, as deteriorating liquidity (in particular in credit) has made life very difficult for many large investment firms. Our sixth recommendation would therefore be to take advantage of what we call ‘life cycle dynamics’. Don’t seed new investment managers, but be prepared to jump on the bandwagon relatively early, as younger and smaller managers often deliver superior returns.
Finally, redemption terms are not always ‘respected’ and, consequently, there is now a sizeable secondary market in alternative investment funds. Don’t let your investment decisions be driven by what’s on offer at the moment but check, once the decision to invest has been made, whether you can actually buy it at a discount in the secondary market. Our recommendation no. seven would therefore be to seek out secondary market opportunities.
The last paragraph was supposed to be the final one, but there is actually one more issue that I should mention, and that is fees. Fees for active fund management – whether traditional or alternative – are (in most cases) far too high in a low return environment, and I would strongly recommend that:
- exposure to beta risk is obtained through passive (index) investments which are much less expensive; and
- investors become more aggressive when negotiating fees ex-ante.
Whilst I entirely agree with the overriding philosophy that it is the net return after fees that really matters, in a low return environment fees do make a big difference to the bottom line.
I believe that if an investment strategy along the lines of the above mentioned ideas were implemented, the risk premium would no longer be 4-5%, but almost twice that. The exact number would obviously depend on how the assets are invested – in particular how much is allocated to traditional vs. alternative investment strategies. That said, I would encourage investors not to think about it as a choice between ‘traditional’ and ‘alternative’, or even about investing by asset class at all. Instead, particularly in a higher correlation environment, investors should focus on risk classes and seek to gain exposure (as efficiently as possible) to different categories of risk, where the return drivers are entirely independent of each other. Too often, several risks are combined within an asset class, making it very difficult to determine exactly what types of risk you are exposed to. Thinking about ‘pure’ risk categories will help you achieve genuine diversification in an environment where this is increasingly difficult to achieve.
6 June 2016