The Cautious Investor Conundrum
The investment landscape has changed greatly since the start of the credit crisis in 2007. Investors in all asset classes and geographies were initially put through the mill as large financial institutions spectacularly failed, but since the market lows of early 2009 those who held on or, better still, invested when prices were depressed have enjoyed a remarkable rebound in asset values. Below I will outline how we see the investment vista from the prevailing high altitude valuations, and how we can position our client and fund portfolios in response to this view. The situation is particularly problematic for the cautious investor who doesn’t want all their eggs in a basket of shares. First I will give a brief description of one of the tools in our investment toolbox.
Value measurement in asset classes
One of the measures I use when comparing the relative merits of different asset classes is the prospective returns available at a broad, index level (eg. the FTSE All Share for equities, or the iBoxx indices for bonds). The way I calculate this uses a concept called mean reversion. I will save the details for a geek’s note sometime in the future, but the idea is that returns in the long run are broadly constant at an average for each asset class, with the shorter terms wobbles canceling each other out. It's a bit like pride coming before a fall, or a decent batsman being “due some runs”. Imagine a market that goes up strongly for a period; intuitively you know that the bull run can’t go on forever and will be followed by a time in which the market goes sideways or falls, so that the overall return matches some average. We’ve seen this in action recently in a combination of the 90s tech boom in share prices, followed by the last decade of disappointing returns.
By using certain measurements it is possible to estimate at any given time what a return to average implies for prospective investments in each asset class. When we allocate assets to, say, shares rather than bonds, it is in part these “top down” views that inform our decision. However, we also try to pick investments within asset classes (“stock picking”) in order to do better than the aggregate return. The possibility of outperformance must also be factored in to our decision making. More on how we’re approaching stock picking at the present time below.
Before that, it’s worth re-stating what it is we’re trying to do when we invest on behalf of our clients. Each client has their own personal aims and objectives of course, but in the most general sense our most basic aim is to preserve the real value of capital, i.e. to provide a return that meets or exceeds inflation. Further, we want to do this whilst minimizing downside risks. And in the ideal situation we try to produce returns that exceed inflation by as much as possible. But again, we want to limit downside risk, and in particular the risk of a permanent loss of capital.
Value in the QE era
We are currently in a time of extremely loose monetary policy, the stated aim of which is to raise asset prices. At least, the Federal Reserve in the US has stated this as an aim. With Western interest rates super-low, and augmented by quantitative easing (QE), the effect has been exactly as intended. Markets for shares and bonds have moved rapidly northward. Mean reversion says this can’t go on forever, and I will now quantify what this means.
I estimate that across world equity markets we can expect returns of 2.7% above inflation (real) per annum over the next seven years. Compare this with the historic US and UK real equity returns of about 7% per annum. That’s a pretty accurate prediction, and I must cover myself and my ego by saying the following: 2.7% will not be in a straight line. There will be periods when returns are significantly above this and below it, and it might not be exactly seven years until we hit the average. The situation in the late 90s suggests that sensible valuations can be forgotten about by Mr. Market for quite some time, but eventually gravity must prevail.
However, I don’t want to try and wriggle out of this prediction too much or the point might be lost. And the point is that prospective returns on shares the world over are significantly sub-normal. But at least they’re positive.
Another major asset class for our clients is fixed income (otherwise known as bonds). This consists of debt issued by governments, e.g. gilts in the UK, and companies, AKA corporate bonds. These are loans, and since loans usually come with a stated interest rate and date when you get repaid, these are, at the right time, a good choice for investors who don’t want all the risk of investing in shares, but want a better return than at the bank.
As a reference point, gilts have historically returned about 3% per annum real, and corporate bonds about 4%. They’re less risky than shares, hence the lower returns.
We have done very well out of bonds in the last couple of years. Since the low point in 2009 UK corporate bonds have given a total return of 28% according to one iBoxx index, and many funds have done much better. That’s about 13% per annum. Less inflation, it’s around 9-10% per annum real, way above the historic average for what is supposed to be a fairly slow and steady asset class.
The first thought that springs to my mind on relaying these facts is “that can't go on forever”. Mean reversion gets inconveniently in the way, and for bonds a focus on real returns is particularly troubling.
The problem with fixed income is in the name. The income you get is fixed. So if we have inflation, the real value of the income is reduced. The higher inflation goes, the less you get after inflation takes its slice. Then when you get your loan amount, the principal, back at the end it's worth less in real terms than when you put it in. At present, bonds offer prospective real returns below zero, and how much below depends on how much inflation we get.
The graph above shows the prospective real returns at different inflation levels for some different types of bond (raw data from Markit as at 1st April, calculations are mine). Note how bad it gets when inflation hits 6%. The current level of RPI in the UK is 5.5%. There are good reasons to think that this will subside over the next year (the Bank of England certainly thinks so) but then again that’s what commentators were saying a year ago, and outside of the West inflation is becoming increasingly problematic. Tony has discussed the inflation debate in his recent blogs. In the US, where current inflation is at a more sober level, there is still concern. Noted commentator James Grant wrote in his most recent edition of Interest Rate Observer:
“If, as and when today’s 2% inflation world becomes a 4%, 5% or 6% inflation world, there won’t be enough Kleenex to dry the tears of the bondholders.”
Without being quite so melodramatic, I agree. Not only does inflation take its slice, but if investors want to sell the bonds before they mature they must get the market rate, which will be low if the buyers are worried about inflation.
So what do we do?
So we have the prospect of sub-normal equity returns and poor-to-much-worse fixed income returns, depending on the inflation level. Where do we go?
For more risk-tolerant investors the answer is straightforward – buy shares. But be selective.
No matter what level of risk you’re willing to take, we always try to be prudent in our share selection and buy at levels that imply a margin of safety (i.e. when things are cheap) just in case we’re wrong. At the present time we think this is particularly important given the elevated price levels of shares as a whole. Our focus on quality and cheapness has brought us to invest in some solid sectors, including healthcare and consumer staples. These are typically very large companies but we have also got a team of smaller companies in our portfolios that also meet our investment criteria. We think that these companies are not only cheap but also have characteristics that will grind out fundamental returns for investors even in harsh times. Hugh expands on the qualities we look for in companies in his monthly investment views.
However, for the cautious investor who doesn’t want 100% shares, where the portfolio should be invested partly depends on where you think inflation is going to go. If you think that inflation is going to remain low, there’s not so much problem. Bonds are a bit overvalued but if you select your corporates carefully you can see a real return.
The real issue is if inflation rises (in the case of the US) and/or stays high (in the case of the UK). Naturally we don’t know whether this will happen, but because of the asymmetry of bond returns, where things are just about ok if we have low inflation but disastrous if we have high inflation, we should think very seriously about protecting against inflation.
Luckily there are some answers, and although they’re not perfect they are somewhat better than the traditional alternatives. One of these is index-linked bonds.
Governments and some companies issue debt that has the face value linked to inflation (usually RPI). Say you buy an index-linked bond with a face value of £100, and in the first year the RPI increases by 5.5%. At the end of the year the face value is increased to £105.50. Because the income is a percentage of this new face value, the income goes up as well. When the bond matures, you get a face value that has risen with inflation, plus some income on top to make up your total return.
We like this type of bond for those that want less volatility in their portfolio. They do have issues however. Firstly, the nominal income that you get from them is low (something around 2% for corporate index-linked bonds), a bit of a problem for income-oriented investors. This can be remedied by selling some of the bonds each year but many find that clunky and unappealing. The second issue is that these bonds are relatively expensive; mean reversion suggests a negative real return of about 1.3% per annum. However, compared with -8% for ordinary gilts and -5% from cash (assuming the current base rate and RPI inflation) that doesn’t seem too bad. Plus it matters much less if inflation really gets going, because the face value still gets marked up in line.
We are looking into other bond-type investments that help to protect against inflation, which may present further options. However, in the search for return we need to be vigilant that we don't take on unnecessary risks, or we might end up like Jim Grant’s bondholders.
In conclusion, the options for all investors are somewhat limited at present but we can still see reasonable places to invest. We favour shares in high-quality companies as the main constituent of long-term investment portfolios. But for those that want or need less volatility risk we must look away from traditional fixed income investments to maintain the real value of assets.
Ben Peters, April 2011
P.S. In the budget it was reported that National Savings and Investments Index-Linked Certificates are about to be issued again. The previous issues were a great place for cautious investors to protect against inflation, and will post on the new issue when we have more details.
Please note: this investment view contains the personal views of Ben Peters at 6th April 2011 and does not constitute financial or investment advice.