1. Current investor challenges
2. Passive versus active investing
3. Multi-asset solutions and RDR
4. Risk targeted funds
Tutors on the panel are:
Sam Mettrick, Head of UK Advisory Sales, Henderson Global Investors
Bill McQuaker, Head of Multi-Asset Investing, Henderson Global Investors
The implications of low bond yields for investors and savers
Sam Mettrick: It’s the political uncertainty and economic weakness we are currently seeing, allied to high levels of sovereign debt, is making life particularly challenging for investors.
Among the most significant issues, as highlighted in the chart, are: slow economic growth, equating to slow or no wage growth, not to mention the threat or reality of redundancy. So there is an added pressure for the success or reliability of investments. The effect of quantitative easing, the £375billion programme of the Bank of England to buy gilts has been to drive down yields. This is important because interest rate levels are linked to gilt yields, and it means that UK savers are facing poor returns on their savings accounts. Meanwhile, company pension funds rely on bond income, including government bonds, to help meet their liabilities. As bond yields have shrunk since the sovereign debt crisis began, liabilities have therefore also risen by an estimated 40 to 50% according to recent research from The Economist. The result is that companies are having to put more money into their pension schemes instead of other areas such as salaries or expansion.
It is worth pointing out that ordinary people who are saving for their own pensions or who are part of a defined contribution scheme lose out as well from low gilt yields. Their pension pot buys a much lower retirement income in the form of annuity than before. In turbulent markets, such as those we have been seeing, there is often increased risk aversion. This explains why many investors have switched to the perceived safer havens of government bonds or gold; the inflated prices of such assets follows, representing a premium for safety. This premium may subsequently disappear, resulting in investors losing money in what they considered were safe investments. In such an environment, where returns are hard to find, the challenge is to be aware of the risk versus return characteristics of where your money is.
The pronounced volatility in financial markets we've seen in the last few years highlights the difficulties associated with investing successfully. Predicting where the best investment returns are likely to come from in any one year on a regional, country or company basis is as difficult as ever. The chart illustrates the great variability in performance of the major classes of investment chosen by UK based investors. In the 14 years shown in the chart of percentage annual returns, which takes in the periods before, during and after the credit crunch, you can see how often an investment can follow in a period of good performance with a period of bad performance.
Take Europe Equity for example. This produced an impressive 17.16% return in 2012, but was near the bottom of the pile in 2011 and 2010, with -13.85% and 5.66% respectively. In 2009 it was back up near the top, with 19.25%, while in 2008 it delivered a disastrous -23%. The chart demonstrates the risk of being in the wrong investment at the wrong time. It also demonstrates the wisdom of diversification, the investment approach of not having all your eggs in one basket can help achieve the right balance of risk and returns.
So what are the major factors investors should be aware of when it comes to how investments perform? One is the extremely low rates available on cash, a perceived risk free asset, we have been seeing, which may remain for some time. The top charts on the slide show bond yields in the US and the Netherlands over several centuries. Government bond yields such as these are closely linked to interest rates, which means those countries are currently facing the lowest returns on cash seen for centuries. Likewise, the bottom chart shows the UK, first its similarly low interest rates and also its historically high level of debt.
Typically during times of low or no economic growth, a government will try to stimulate the economy by reducing interest rates, which encourages more lending and investment. However, UK interest rates are as low as they can realistically go and the government deficit is very large, which makes direct government spending more difficult. An advantage of the quantitative easing mentioned earlier is that because governments use newly created money to buy back their own debt, it does not add to the national debt figure.
Investors should also be aware of the impact of inflation and currency movements on investments. While inflationary pressures in most countries are relatively slight at the moment, this next chart shows what can happen when inflation is high. It picks the 1970s – some of us are old enough to remember them – to show what can happen as a result to prices of everyday items. For example, a standard loaf of bread cost 9p in 1970, 33p in 1980, a rise of over 266%. Over the same period, a typical house rose in price from £4,975 to £23,290, a massive uplift of 368%. The 1970s was an unusual period, due in particular to massive rises in energy prices, but just imagine how well your investments would have to perform to maintain your purchasing power.
Inflation is in fact always a significant risk to your investment, because it can erode their real value. As we have mentioned, currently returns on cash are very low, which means that inflation does not have to be very high in order to seriously damage returns. The UK consumer price inflation figure for March was 2.8%. The retail prices index, RPI inflation figure, which includes housing costs, was 3.3%. Compare these with typical savings rates.
Likewise, currency movements have the ability to provide surprises, this time on the upside or the downside, as this next chart illustrates. It highlights some major currency crises seen around the world in the last twenty years or so. Take for example Black Wednesday in 1992, when sterling was withdrawn from the exchange rate mechanism, after the Government invested heavily to maintain the exchange rate while international investors made huge amounts of money by betting in the opposite direction. More recently, the Icelandic financial crisis was one of the many dramas that played out during the credit crunch. Bear in mind though, while major shocks happen only occasionally, overseas investments all carry with them the additional risks associated with currency movements.
Equity producing assets – an overview
Not wanting to be overly gloomy in this film, I would like to turn to an often overlooked aspect of investing, the importance of income. Many different types of asset produce income, as the chart shows. Look in particular at the strong income qualities of property, underpinned by rents from commercial property tenants and the decent dividend yields on UK and European equities. This regular flow of cash can provide a substantial boost to potential total returns, including at times volatility and prices.
The chart also shows how income yields can change over time for different types of asset. Look for example at the changes in yields in the various types of bonds, which have typically fallen as investors have sought them out and thus pushed up their prices. As you can also see, and I said earlier, cash returns have moved to extremely low levels. Looking specifically at income from equities, it is sometimes forgotten how important dividend income can be in total equity returns, with attention focusing too much on equity price movements.
The next chart, looking at major equity markets since 1981, shows how powerful the income effects can be. The regular contributions from the dividend yield plus dividend growth, the bright red and dark blue bar sections, compounded year after year over the thirty year period dominate multiple expansion, the green bar sections, which is the part of a rise in a share price due to investors being prepared to pay more for the same level of earnings. This latter price effect in other words is relatively transient and can be negative, while the income return is more enduring over the longer term.
Volatility and correlation
While income can enhance returns and sometimes smooth them, volatility is always present in investing. Volatility is a measure of how much a fund, market, index or a security moves up or down over a certain period. Investment performance charts often show fluctuating rather than straight lines. In fact there is a well-known volatility index known as VIX, also sometimes called the fear index, in full the Chicago Board Options Exchange Market Volatility Index, that measure the implied volatility of US equities in terms of the S&P 500 index.
VIX tracks short term futures prices as a proxy for the mood of the market, and in the VIX chart over the last ten years you can see the heightened volatility, fear, during and since the credit crunch. You can also see the subsequent swings from pessimism to optimism. Standard deviation is the most common measure of volatility, which is often crudely described as risk. Standard deviation, as described in the chart, is a statistical measure of the dispersion of returns. The more diverse the returns are, the higher the standard deviation and therefore the higher the volatility. A rational investor would be looking for an investment that has high expected return with the lowest possible standard deviation.
I would like to turn now to correlation: an important measurement of how investments behave. Correlation measures the extent to which two assets have a directional relationship. When two assets are highly positively correlated, they tend to move in the same direction. This is represented by a positive figure between zero and +1 in the chart, and the closer to +1 the figure is, known as the correlation coefficient, the more they move in the same direction. When this figure is close to zero, there is little or no relationship. In contrast, assets that are negatively or inversely correlated will tend to move in the opposite direction to each other, and this is represented by a negative figure between zero and -1 in the table.
So how can this, combined with other evidence we have looked at, inform a sensible approach to investing? Number one, since assets have different risk and return profiles, a blend of assets can potentially smooth out some of the volatility and offer a more attractive risk adjusted return than a single investment. Number two, be aware that the fall in the value of one asset may lead to a corresponding rise in another. This is known as inverse correlation, and occurs because different assets behave differently and are perceived as attractive at different times in the economic cycle and under different market conditions.
For example, when the economy is weak and confidence is low, investors may sell riskier equities, causing equity prices to fall, whilst favouring the relative safety of government bonds, which would push up these prices of bonds.
Number three, understand that typical correlations may change. During the most volatile period of the credit crunch, returns from different assets were hit, including some that had previously showed low correlation. Number four, different types of assets have different characteristics; some have a focus on income, others growth, whilst others offer low volatility. A comprehensive diversified multi-asset investment approach offers exposure to these characteristics and can potentially profit from the periods when characteristics outperform.
An introduction to multi-asset funds
In this next section I would like to introduce you to multi-asset fund investing. Professionally managed multi-asset funds that contain holdings in other funds and investment vehicles can help investors overcome a number of the issues I have covered so far. By allocating to a broad range of investments, they provide exposure to a variety of asset classes, regions, sectors and fund management styles, often on a global basis. This helps to spread risk, reduce the impact of market volatility, particularly when compared to funds that, for example, are restricted to a specific asset class or region. In addition, investors benefit from the expertise of professional fund managers who are able to rotate the portfolios towards those areas of the market where they believe the best opportunities currently lie.
There are different types of multi-asset investment approaches, and some important definitions. Fund of funds and multi-manager investing tend to describe the same thing, holding a portfolio of other investment funds rather than investing directly in stocks, bonds or other securities. A fettered approach involves investing only in funds managed by the same group, unfettered involves investing more widely in funds from other groups. However probably one of the most important areas of debate in recent years is the multi-asset world has been between the merits of active and passive investing.
Active vs passive investing
Actively managed investment funds are run by a professional investment team who make all the investment decisions, such as which companies or funds to invest in or when to buy and sell different assets on your behalf. They have access to a wealth of research and often meet companies or other investment firms to analyse and assess prospects before making a decision to invest, and also to check on progress of existing investments. The aim with active management is often to deliver a return that is superior to the stock market that the companies sit within.
An actively managed fund can offer you the potential for higher returns than what a particular market is already providing, or an actively managed fund may have investor risk as the primary driver, seeking decent returns while also ensuring the fund is managed in line with the investors’ attitude to risk. Active management also means that you have somebody tactically managing your money, so when a particular sector looks like it might be on the up or one region starts to suffer, the fund manager can move your money accordingly to expose you to this growth or shield you from potential losses. They will also seek diversification in order to reduce risk.
Passive investment funds simply track a market, with the funds essentially run by a computer. They will buy all the assets in a particular market, or the majority, to give you a return that reflects how the market is performing. The passive approach requires fewer resources, is therefore cheaper. This is important because multi-managers need to be cost conscious. Charges reduce returns to investors.
The chart summarises the plusses and minuses of active and passive investing. On the plus side, active investing offers the potential to outperform, can react to changing conditions, can also take steps to reduce volatility, and is backed by professional analysis in order to exploit market inefficiencies. Passive investing offers lower charges, returns in line with market indices and lower portfolio turnover. On the negative side, active investing is more expensive, may underperform. Passive investing is unlikely to outperform or address volatility and returns will suffer in line with any index falls. It is worth adding that there are increasing numbers of investment approaches that are seeking to blend the best of active and passive investment approaches and to address the negatives.
So, in summary, we've seen how complex and challenging markets are, and how events such as 1970s inflation or the 2008 credit crunch can have a major effect. In the bull market leading up to 2007, most things went up, especially equities, and therefore some investors lost sight of the risks inherent in investing and the importance of true diversification. Asset allocation had become less critical. Multi-asset investment has continued to evolve and focusing on returns and risks. It can also be transparent and cost effective. It provides investors with more opportunities, greater flexibility and particularly important in recent years enhanced diversification potential. All of which are what investors and advisers are looking for and should serve them well in the years to come. Thank you for watching.
The characteristics of a well-managed multi-asset product
Presenter: Well Sam Mettrick has covered the theory of multi-asset investing, but what about its practical implications? Well, to discuss these, I'm joined now by Bill McQuaker, who is Head of Multi-Asset Investing at Henderson Global Investors. There are many different types of multi-asset fund, as we've seen, what are the relative merits of each?
Bill McQuaker: Let me perhaps describe what are the characteristics one would like to see in a good approach to multi-asset investing. I think there are four or five elements. The first is actually in the title of the product, multi-asset. At the heart of a high quality multi-asset fund is an appropriately structured portfolio, and appropriately structured has got two elements to it.
The first is an appropriate level of diversification, with the aim of reducing volatility or smoothing the ride is, I think, an elegant way of thinking about it, and that relies on us having a proper understanding of the volatility of different assets, how they relate to one another, and perhaps where the artistry, if one wants to think of it in those terms, comes in, understanding how the world might develop and how that could impact on those volatilities and correlations. Those skills, that knowledge is at the heart of building a robust, diversified portfolio that will deliver, not regardless of what happens in the world, but in many different economic and market circumstances.
The second piece, in terms of structuring the portfolio, revolves around understanding the world, what’s happening in the world, how that maps onto what’s happening in financial markets and the relationships between political economic events and market prices, and then identifying a subset of opportunities where we think we can deliver the diversification that I described a moment ago, but also deliver a rate of return that is consistent with the requirements of investors.
And that second piece, a metaphor that I think’s quite helpful in this area is to think of a dashboard of information sources, a set of dials that tell us about the macroeconomic climate, a set of dials that tell us about market conditions in terms of valuation and fund flows and how people are positioned, whether the fund managers are very exposed to an area where a change of circumstance might mean there’s a lot of money to come out, and so on and so forth. And we piece all of those things together to build as complete a jigsaw as we can of what’s happening in the financial markets arena, and then identify the right set of assets to deliver the returns that investors want.
So that’s the first two things. On top of that there are issues like controlling costs. I think clients have become more aware of the cost of fund management, and they look to people like my team to monitor and manage down costs, and we put quite a lot of effort into doing that. And then there can sometimes be other characteristics that investors want to see built into a product to make it appealing.
One of the key characteristics in today’s environment is delivering income to investors. For we live in a world of very low interest rates, very low bond yields, and there’s a real requirement on the part of many people to generate an acceptable level of income from their assets, for the simple reason that they need money to pay the bills. And so we've worked hard to build portfolios that make sense from a diversification perspective, make sense from a capital return perspective, but also have a yield generating capability that also has some robustness to it.
Research and manager selection within a multi-asset portfolio
Presenter: What’s the research and selection process that a fund manager such as Henderson would undertake when putting together a multi-asset fund, and how does that differ from what a financial adviser can do?
Bill McQuaker: I think the process that one goes through is - multi-stage is probably a good way of describing it. Often our first port of call, when we look at a new asset that we perhaps haven’t analysed before, not in great detail in any case, is to look at the asset from a purely quantitative perspective, and we have built quite a number of different tools for both mutual funds and for ETFs and derivatives that are designed to tease out the different characteristics of different products. And even in a space like exchange traded funds, tracking funds, where the temptation is to think that these funds are very generic, that’s not true, and there can be differences in terms of costs, in terms of the degree to which they track the index, are supposed to track, and so on and so forth. And the job of the analyst at that point in time is to ascertain what the key characteristics of the strategy, whether it’s a passive or an active strategy.
The next piece is usually conducted through face-to-face interviews with managers, and again it’s an exercise in teasing out as deep an understanding as one can have of the management philosophy, how that philosophy is reflected in the portfolio, and how the portfolio is positioned, and by extension what factors might influence its performance tomorrow, for better or for worse. And a lot of information is gathered through talking directly to managers, through reading the material that is available in terms of funds, to arrive at a view as to whether it’s a fund that has the right quality, has the right structure to deliver the performance that we’re looking for.
And then the third piece is keeping up to date with changes as they unfold, and those changes can revolve around occasionally a change in management philosophy, how the fund is actually run, more often changes in terms of personnel, and perhaps most often of all changes in terms of the way in which the strategy is actually being reflected in portfolio positions. Everything I've described I think could be achieved by a financial adviser. There’s nothing that is rocket science. However, what I've described is very time consuming, building up that body of knowledge and keeping it up to date takes time, and if one owns hundred different assets, that’s hundred different assets that you need to keep that body of information live for. I think that’s a big ask for advisers.
Presenter: And how do risk targeted funds work? What are the relative pros and cons?
Bill McQuaker: Risk targeted funds revolve around building an asset structure to deliver a level of volatility that’s consistent with the risk preferences of clients. And perhaps I should start by describing the process by which financial advisers determine the risk preference of clients, for there are questionnaires, attitude to risk tools that ascertain how much appetite or how willing different investors are, different people are to bear investment risk. And these tools are relatively sophisticated. It’s not based on just a handful of questions; there’s quite a body of work that lies behind the questionnaires.
At the end of the process, they deliver typically a number between two and ten that summarises a client’s attitude to risk. That is half the solution for the financial intermediary. He now has some measure of the degree to which a client will bear risk. What we provide is a set of funds that map onto those levels of risk appetite, so we build funds that similarly are ranked two to ten, depending on the level of risk embedded in the portfolio. With the Henderson multi-asset core solutions range, we have funds between three and six, because the vast majority of investors fall between those two limits.
In terms of how the portfolio is built, there are two competing approaches. One is to use the asset allocation that is recommended by the firm that has built the attitude to risk tool and based the portfolio around that, it’s a perfectly viable approach, but a second, and we think sometimes better, approach is more holistic in nature. There are any number of combination of assets that can deliver a volatility of five, and if we have a more open architecture approach, a freer approach, then we think we can build a better portfolio, both in terms of the riskiness of it and in terms of its return potential, and that’s the avenue that we tend to go down.
The asset allocation process
Presenter: And when you're putting a multi-asset fund together, what is the asset allocation process, and how does it add value?
Bill McQuaker: The asset allocation process is quite complicated, I think it’s fair to say, in as much as we, a way of thinking about it is as a two stage process. Assets, as I described earlier, have got different volatilities and correlations, and expected returns attached to them. And the first stage of the process is to build a robust longer term portfolio that is an elegant blend of risk and expected return that we think if we just bought and held that portfolio for the next five or ten years would deliver a level of risk that’s consistent with the client’s appetite for risk. That’s stage one.
Stage two is how can we nuance that portfolio, how can we change its shape on a shorter term, more tactical basis, to either improve its risk characteristics or to improve its return potential? And that is the stuff of my life, and determining how to make those shorter term tactical changes is driven by a wide variety of different factors. Some of which are important at some points in time and not at others, others are fairly constant in terms of being significant most or even all of the time.
So what am I talking about? I'm talking about the macroeconomic environment we’re in, the outlook for interest rates, the outlook for economic growth, and going back to my dashboard metaphor, there is a wide variety of tools that allow us to determine where we are now and to have some prospect of determining what might happen to these variables in the shorter term. And then alongside that there’s a bunch of market driven variables like valuation, like positioning, like fund flows, that also feed into the process of determining what looks attractive on a short term basis.
And so to try and bring that to life if you like, if one looks at the Japanese equity market, it’s been one of the more interesting markets in 2013. We've done quite well out of what’s happened in Japan in 2013. Why was it of interest to us? It was of interest because from a valuation perspective Japan has looked very cheap, if one makes one or two assumptions, which may or may not turn out to be right, with regards to returns on capital employed in Japan. Japan, Japanese companies under earn versus Western companies. One of the reasons they under-earn is because Japan uniquely has faced deflation for the last 15 years. Prices have fallen in Japan year after year, and that’s made it very difficult for companies to achieve an adequate return on capital employed.
Now, starting from November last year, we've had a change in circumstances, political and also more broad than just political, that has opened the door to potentially ending deflation in Japan. That’s certainly the policy aim of the government and of the Bank of Japan, and our view is if Japan is successful in tackling this deflation problem, then the value that’s been locked in the Japanese stock market for quite a long time might start to make itself, might start to be released, make itself available to investors. So those types of developments are the meat and drink of asset allocators, and that’s what drives our decision making.
Presenter: And having major asset allocation decisions, how do you express that through fund and stock selection?
Bill McQuaker: I think the piteous way of summarising it is that it’s an exercise in finding horses for courses. So for some investments, if we’re, perhaps we have an expectation that a market will perform radically differently from other markets in the world, and Japan may be a good example of this. Japan has significantly outperformed every other market in the world through 2013. Investors will have reaped most, perhaps even all of that additional return, if they’ve just bought the Japanese index. Buying an active fund to add another 2 or 3% on top of a 30% return from the index, it’s nice to have but it’s not outcome defining. The challenge really with Japan was just get exposure to the Japanese index, preferably without the yen attached. That view says well let’s just buy the index, let’s buy a low cost tracking vehicle, let’s buy a financial future, let’s manage down the cost side of the equation and still get the full benefit of our view, because we think that Japan will perform significantly different from other markets.
So that will be one example where one is buying a vehicle that is low cost and still harvesting most maybe even all of the benefit of a view. A different area though is the bond element of portfolios. We live in a world where investors, as I mentioned earlier, there’s a lack of income, there’s a concern that bond yields have been driven down to very low levels, and that if circumstances change for the global economy, yields will start to rise and people will suffer losses in bond portfolios, which clearly no one welcomes. One of the questions that we regularly ask is how do we intend to navigate through that period as it unfolds?
One of the answers, it is only one of the answers, but one of the answers is we are keen to employ bond managers who've got very broad mandates, who can behave relatively aggressively, relatively tactically, who can utilise the skills that they have and the toolkit they have in as complete a way as possible. We will pay fees to those managers to access those tools. So that’s an example where the return from the asset class is perhaps from risk of being disappointing, maybe even negative, but we think that by paying active management fees we can still gather some returns, even if the overall environment is difficult. So again it’s this question of trading cost against outcome as efficiently, as elegantly as we can.
Presenter: Bill McQuaker, thank you very much.
Bill McQuaker: Thank you.
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