Today’s standard narrative is that investors are being forced to take ever higher levels of risks because Central Banks have helped drive down the yields on safe assets.
At the same time, the investment industry is perhaps more than ever focused on the short term. Measuring the success of fund managers increasingly involves the examination of specific phases: how a fund behaved in January this year for example, or in August 2015. Drawdowns and volatility are now the preferred measures of risk.
But with more and more emphasis being placed on the investment journey relative to the destination, are we at risk of losing sight of the latter in our quest to sleep better at night? How do we reconcile ever lower yields on less volatile assets with a growing obsession with avoiding volatility?
A quick look at a range of conventional valuation metrics instantly reveals the current situation as being unusual and quite extreme. It suggests that there prevails a deep scepticism and pessimism about the durability of future returns on capital, with a resulting preference for assets with higher degrees of certainty about a return of capital over those with some degree of hope for future growth.
In addition, investors continue to exhibit a myopic focus on the desire to avoid volatility and the risk of short term loss with an intensity that did not exist in earlier decades. This aversion to short term loss and volatility is prioritised over the potential for material upside and ‘growth’. There has always been a tension between ‘risk and return’ objectives but it seems that today, investors in aggregate now view low volatility as the latest “holy grail” and are willing to sacrifice the possibility of stronger returns in order to achieve it. Both theory and history tell us that this situation will change – eventually!
This preference for “safety” and capital preservation can be seen in the very low or even negative yields on sovereign bonds in many economies. Investors have significantly reduced the rates of return they require to lend money to governments. In the last year or so, these rates of return have fallen below zero, with investors effectively paying to lend money to governments; something most people saw as highly improbable.
In the post 2008 environment, this volatility averse behaviour has not been an expensive behavioural trait. In fact, it has proved highly profitable to maintain a cautious or negative view, so long as this has manifested itself in a tendency to own exposure to sovereign bonds of longer duration. Interestingly, a cautious perspective that was represented merely by shorting or avoiding equity has not been beneficial. Strong performance from both bond and developed equity markets has been a surprise and a source of much confusion.
So, biasing portfolios towards being long of government bonds has been a rewarding strategy since 2009. Longer-dated bonds in the US, Europe and Japan have produced substantial multi-year capital gains of the type more often associated with riskier assets such as equities, as yields have trended lower. In addition, they have continually behaved like insurance policies, as they have responded most positively in phases of stress for risk assets, thereby cushioning portfolios in downdrafts.
This pattern of behaviour has been hugely beneficial to portfolios that have had a pro-mainstream government bond disposition. Importantly, though, the magnitude and durability of this phase has been a surprise to most, including those who have benefited from it! More importantly, the reality is that this is a finite game. Strong capital gains from bonds come at the expense of future returns – as yields fall we can see our prospective returns decline. It is effectively taking some of the future returns up front. Interestingly, from a behavioural perspective, it never “feels” like that. The gains from a transition to lower future returns can distract investors and cause them to want to continue to enjoy the journey, even if they actually believe it to be unsustainable! This emotional dynamic has been very clear in this latest phase.
Our assessment is that we have arrived at a pivotal and potentially critical moment in time, where a material change in investor thinking and behaviour is needed. The reality is that with valuations as they now stand, a continuation of existing attitudes and behaviour is likely to lead to disappointing and possibly very negative nominal and real returns. The strategies that have been successful for the last decade are now likely to struggle. As ever, conclusions such as these, based on valuation signals as they are, do not tell us much about the immediate future. It is possible that current behaviours persist or even intensify, with valuations becoming even more extended. We have seen similar things before, where valuations become highly stretched and investors suspend all normal beliefs about the pricing of risk. Ultimately, though, gravity re-asserts itself and the results can be disastrous.
This perspective relies on our long-held belief that volatility is not equivalent to risk. In our view, true risk is more a function of the possibility of more protracted or permanent loss of capital. In our view, an obsession with volatility is counter-productive and misses the point about what actually matters on a multi-year view. Owning assets that have in the past delivered good returns and had attractive risk characteristics, but now stand on valuations that imply this cannot be repeated is a dangerous strategy. Whenever ‘de-risking’ a portfolio involves moving from cheaper to more expensive assets, then alarm bells should ring.
So, our belief is that volatility aversion, extrapolation of recent abnormal trends, and a significant deterioration in economic beliefs have produced a valuation mis-alignment and an extreme dis-equilibrium in market pricing. This situation could persist or intensify, but we believe it will correct in time, and will produce some significant surprises when it does. In order to exploit this situation, investors will need to change course and be willing to focus less on short-run volatility and more on sustainable attractive returns. This is uncomfortable and emotionally challenging but we believe the reward for doing so will prove it to be most worthwhile. The costs of not doing so could be significant.