The long game of investing

06 February 2017

Jonathan Armitage

Jonathan Armitage is the Chief Investment Officer at MLC. Jonathan assumes overall responsibility for the investment outcomes of the MLC portfolios.

In a low growth, low return environment, investment managers need to be more prepared, and more risk-aware than ever. This article will examine the long game of investing, when return opportunities are scarce and the lure of alternative assets are in this landscape.

This article is for educational purposes only and is no longer available for CPD hours.

Macro environment

We are in a low growth, low return, ultra-low interest rate environment that is close to being unprecedented and it’s a challenging environment for investors. The key priority is working out the best way to continue to manage clients’ portfolios, while being very wary of the unique risks this environment poses.

Economic drivers

When thinking about the drivers behind this low interest rate, low growth environment changing, one thing I pay attention to is what is happening in the US.

At the moment there is significant focus on whether the Federal Reserve will raise rates.

Economic activity in the US continues to be quite robust – wage growth has picked up, and there is now quite a difference between what markets are saying forward interest rates might look like and some of the underlying data we are seeing from businesses about wage costs which are starting to increase.

This all suggests the pressures around wages, one of the key contributors to inflation, are starting to pick up.

However, that is contrary to what we are seeing in Australia. Wage growth here has been quite anaemic.

We are seeing some differentiation with what’s happening in the US, where the Federal Reserve is moving towards normalisation of interest rates, and in many other economies where that appears to be some way off. For example, Japan continues to ease monetary policy.

Key risks

There are a number of key risks that advisers and investors need to manage in this current environment.

The biggest risk is that as investors search for return, they move up the risk curve and end up investing in things they don’t understand, and are tempted into investments that on the surface look okay but actually carry much greater risk.

Given where bond rates are, using that as a discount on future cash flows, may be the wrong answer. Valuations in a number of asset classes have moved because interest rates are so low.

I am wary that investments normally seen as very defensive, such as some government bonds, may not be as defensive given how low yields are.

You have over 50 per cent of the stock of global government bonds now subject to negative interest rates, so these investments would no longer have the defensive characteristics investors would have counted on.

Another key risk continues to be that central banks and governments make policy mistakes.

Whether the US Federal Reserve is behind the curve and inflationary pressures are building to a greater extent than people currently anticipate, or that continued monetary easing is just ‘pushing on a piece of string’ and not working – the risk of mistakes is significant.

If these policies are pursued, we will see more cheap money coming into the market, which pushes asset prices further and valuations become stretched. This is a risk because at some point, valuations can get to a level where they aren’t sustainable.


So, what are the game-changers emerging for Australian investors?

The most interesting possibility is that the Australian dollar will end up weakening.

The currency has always acted as a safety valve in Australia; you can see that coming in through economic data – tourism has picked up and exports are up. It is possible that the dollar may end up much lower than it is now.


What is particularly interesting for advisers and their clients is the fact that there are a number of ways investment managers can get a competitive edge in this environment and deliver decent performance.

The key here is having flexibility in terms of the way you think about asset allocation, and around the way you manage risk.

For example, our asset allocation is quite conservative at the moment. Our cash weighting is relatively high, we have changed our exposure to fixed income – we have brought it down and have focused on shorter duration opportunities.

We have also continued to hold our exposure to alternatives – including private equity and our low correlation strategy.

Our low correlation strategy is a hedge fund-of-funds investment, that finds returns in components that look very different to equities and fixed income.

Lessons learnt

There are definite lessons we can learn from other markets about successful investment strategies in this kind of environment.

History teaches us that it’s so important to be clear about your objectives and focus on how you manage risk. If something looks too good to be true, chances are it is.

If you look back at history, you can see the build up of mistakes prior to a crisis. The warning signs are usually there – and the watch-out is not to be so entirely focused on return that you forget about risk.

For example, now we are again seeing the emergence of complex and opaque instruments that investors don’t really understand. Leverage has been increasing again – personal debt in the UK is now as high as it was in 2007, just prior to the GFC. Cheap money encourages people to take too much risk and makes them very vulnerable to changes in short-term interest rates.

Many investors have experienced a period of strong investment returns, so we need to do a better job in educating investors about having realistic expectations about the returns that are available in this environment and the importance of managing risk.

For investors in accumulation phase, I encourage them to stay the course. The lesson post GFC is that people who were still a long way off retirement and held the course recovered, while those who cashed out too soon lost a lot. Not making short-term decisions is important in this environment.

For those closer to or in retirement, it is critical to make sure they understand the risks of what they’re investing in and have clear outcomes in mind, rather than just short-term returns.

For example, we created the MLC Inflation Plus portfolios, so we could give investors an outcome focused investment option that was strongly focused on risk management.

Alternative assets

There’s currently a lot of buzz around alternative assets as a good option for higher returns. So, why is there interest in this asset class?

This interest is as much driven by the fact that we’re in a low return environment and the valuations in equities and parts of the fixed income market are at unattractive highs. So, alternatives are getting a lot of attention.

When it comes to the types of alternative assets I’m focussing on, I look for assets that are uncorrelated with mainstream assets and which give us diversification and a different risk profile.

We have a return hurdle of 3 per cent over 90-day bank bills over three year periods. That’s our own return hurdle, but if you do that, particularly in a weak equity market environment, that’s a very attractive return.

To achieve that, we started building a strategy in 2008 that we now call the low correlation strategy.

It invests in 12 hedge funds managed by 10 different managers but the whole point is they are not correlated with equities or each other. We decided to aim for a beta of less than 0.2 to equities over three year periods – since its inception the beta and correlation has been zero.

Why have we done this? When markets are weak or when markets fall, we wanted part of our portfolios to be very defensive and we wanted a way to manage risk and diversification well.

The low correlation strategy has evolved, so we now have exposure to things like mortgage pre-payment risk in the US. These are investments in securities linked to the risk that US mortgagees prepay their mortgages faster than expected.

This risk isn’t directly connected to share market movements, which makes the strategy an attractive source of diversification.

The securities are also complex, hard to model and require careful hedging, which creates alpha opportunities for skillful managers.

We also have systematic strategies that use technology to process lots of information much quicker than the human mind. These strategies have performed very well for us. In our experience, identifying the best hedge funds requires deep research and a very high quality hurdle.

And there are other strategies that are part of the low correlation approach. For example, we use a manager who incorporates meteorological forecasting, as well as sophisticated supply-demand analysis in order to make money from trading energy futures.

Another area we’ve recently invested in is merger appraisal rights.

This is a niche, distinctive litigation based strategy which involves investing in merger deals where the target company is being acquired at a price that is deemed to significantly undervalue its shares.

What makes this strategy attractive is that there is statutory interest paid to the shareholder pursuing appraisal rights, which is currently cash plus 5 per cent per annum, to compensate them for their capital being locked up during the process. This is paid on top of any uplift to the merger price.

Overall, this investment has potential upside, very low downside risk and a very low correlation to share markets.

What to avoid

There are definitely some types of alternative assets to avoid.

For example, anything very highly correlated to equities and where we don’t think the benefits are exploitable for anything but a short period of time.

One of the other challenges of some of these strategies is that the assets can tend to be quite illiquid and we don’t particularly like that. Although returns are higher because you receive an illiquidity premium, if markets turn against you, you can end up stuck with the investment.

It’s not that easy researching and investing in alternative assets.

If you get a lot of money investing into them, returns will be diluted down. We’ve seen that in the US, where people managing endowments have looked at the returns achieved by Harvard and Yale and tried to replicate them.

If we end up with a $2 trillion industry trying to replicate the same returns, you’re going to get some very poor investment decisions being made.

I think in general that alternatives are a very interesting area but I’m also deeply sceptical and think there are more ways to lose money than there are to make money, so your approach to investing has to be right.

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