Still haunted by memories of the GFC, investors are excessively focusing on yield to the detriment of diversification. Knowing how crises manifest in different ways, they could be putting themselves at severe risk if another crisis emerges, Dominic McCormick writes.
In late August a prominent investment commentator was on a TV business show explaining his reasons why the local sharemarket would continue to boom. The three reasons given were:
1. Interest rates are low;
2. Investors are chasing yield; and
3. A fear of missing out on strong gains.
It strikes me that there is only really one reason here. Low interest rates have made investors chase higher returns from other assets. Of course, in a world of extreme central bank influence and record low interest rates, this "chase" is often pitched in terms of the more attractive "yield" available from other assets such as shares, hybrids, property or infrastructure. In practice however, investors are frequently just chasing what has performed well recently.
Unfortunately, recent returns or even current relative yields provide little future guidance. We also know from history that chasing past returns usually ends badly for investors. Investors are in fact chasing higher risks and to the extent that risk is the chance of not meeting a threshold return or of permanent capital loss, these risks are clearly rising as the prices of these assets rise.
It is clear "yield" has had a major role in enticing investors and has become the dominant narrative driving many investment decisions. Even the most unsophisticated investors understand interest rates on cash and term deposits and the decline in these to record low levels has spurred a demand for alternative sources of yield from investors who would not normally venture elsewhere.
Moreover, this has not just been driven by unsophisticated retail investors. One major fund manager was recently quoted describing Commonwealth Bank of Australia (CBA) and Telstra as bond proxies. When banks, which are inherently the most leveraged sector of the market, are described by investment professionals as a proxy for government bonds we have a problem.
In addition, increasingly I see adviser recommended model portfolios, and I suspect many self-managed super fund (SMSF) portfolios are similar, made up primarily of the following:
1. High yield Australian stocks for the Australian shares component especially banks;
2. Very little in international shares with perhaps one managed fund or global Listed Investment Company (the latter paying reasonable dividend yields but often trading at unsustainable premiums to Net Tangible Assets (NTA);
3. Direct Areits for property yield and possibly also some listed infrastructure stocks; and
4. Hybrids (again mainly banks) for part or all of the fixed interest component.
This obviously is a low cost, simple, transparent portfolio which comes with the advantage that almost all the portfolio is Australian Securities Exchange (ASX)-listed and traded, providing significant benefits to investors, advisers and administrators.
However, such a portfolio is not well diversified nor is it particularly robust in certain investment scenarios. Almost every holding is "yield driven" making it hugely vulnerable in some environments that involve higher interest rates or a general move by investors away from yield. We may already be seeing a test of this vulnerability in recent weakness which has hit yield areas particularly badly.
Charlie Aitken of Bell Potter summarised the dangers well in a recent newsletter. "It concerns me that financial advisors have many of their clients in yield equities and hybrids, but in effect they are held as an alternative to cash or term deposits," he wrote.
There is a clearly a chance of a big mismatch between investors true appetite for risk and the actual risk/volatility characteristics of these investments.
It seems a reasonable bet that the sectors and assets that have been perceived as safer in, and benefiting most from, the chase for yield in the current low interest rate environment (REITs, listed infrastructure, hybrids, Australian banks and other high yield stocks) are the areas that can disappoint most in a period of market stress, particularly relevant to recent lofty expectations.
I am certainly not arguing against using ASX investments as the core or even bulk of portfolios. Indeed, with the increasing opportunity set being made available on the ASX through Exchange Traded Funds (ETFs), LICs and mFund offerings we are heading to a point where one can build robust, well diversified, multi-asset portfolios of ASX listed and quoted investments, something that was not possible even one or two years ago. However, it seems many advisers and investors are sticking with their tried and tested yield investments of the past and are slow to utilise this growing opportunity set. Poor research coverage and limited education around some of these areas as well as a lack of dedicated portfolio construction approaches incorporating these vehicles is a significant part of the problem.
The overall dilemma for investors remains that major central banks' continue to experiment with innovative monetary policy and long periods of low nominal and negative real interest rates. The experiment is only partially completed and investors don't yet know the final results or long term consequences. This is particularly the case as the wind-down of the experiment itself has not even properly started. However, we can be reasonably sure that this period has encouraged certain investment behaviours that will be seen to be foolish in a more normal environment. Markets may not even wait for that exit or normalisation but may lose confidence earlier that central banks can exit these arrangements without major market dislocations. We are set for interesting times.
How can we know that such excesses exist and that future dislocations are likely? Of course nothing is certain but there are some reasonably reliable indicators that an area is becoming overheated and a crisis possible. For example, when you start hearing of certain people making enormous money in an area, or masses of people switching jobs into an area it pays to be cautious. A plethora of new and rapidly growing funds in the area is another warning sign.
Such was the case for real estate agents and mortgage brokers in the US prior to the US housing bust and global financial crisis (GFC). Recently, it was interesting that the co-founder of listed infrastructure group Rare Infrastructure purchased a house in Sydney for $31 million. Australian banks are making record profits and are the most expensive in the world on key measures while their frequent hybrid issues get swamped. It is time to be careful.
So what could investors do to make their portfolios more robust, diversified and less yield dependent? While no means conclusive some possibilities include:
- More overseas exposure - and exposure that will definitely participate in a weaker currency/relative outperformance (LICs at large premiums may not);
- Strategy diversification away from long only equity strategies (e.g. long/short, option based etc.);
- Alternative assets and strategies (e.g. gold, managed futures, market neutral funds etc.);
- More diverse fixed interest exposure; and
- Equity protection (volatility) and/or a cash buffer that would allow for purchases at more attractive values if there is continued serious weakness.
In the same newsletter as mentioned above, Charlie Aitken was quoted as saying "the only clear value I can see is the USD, volatility and Chinese equities". I think this is true as far as it goes but as suggested above there are other ways to diversify. However, it is clear that most investors, especially SMSF investors, have little if any exposure to even these three areas. Now is the time to move away from what seems most comfortable towards things that can seem uncomfortable but which can make portfolios more robust.
It is a challenging time for investors but many investors have made themselves more vulnerable through an excessive focus on "yield" and resulting lack of diversification. While it is totally understandable that investors highly value the liquidity, transparency and accessibility of ASX-listed investments and are drawn to yield in the current low interest rate environment, it is time for investors to be more discerning. They should either consider investments outside the ASX platform in areas and strategies mentioned above or at least explore the increasingly diverse range of options being provided by the growing list of ETFs, LICs (at appropriate prices) and mFund.
Investors risk being wrong-footed because they are focused on making sure they don't get caught with the same issues that hit them so hard in 2008. Because of this they are focused only on the elements of investing that worked well through and beyond the GFC - liquidity, dividends and simplicity. Therefore apart from the obsessive focus on yield, they are wary of less liquid assets, use active managed funds sparingly and avoid complex or higher cost funds. Unfortunately, history doesn't repeat with any reliability and each crisis brings its own variations with the risk that investors may be excluding tools and approaches that could make their portfolios more robust in any future hostile environment. Focusing only on what won the last war increases your chances of not having the right tools to fight the next one.
Dominic McCormick is the chief investment officer at Select Asset Management.