INVESTMENTS
TIME FOR A DIFFERENT APPROACH ?
Ben Mackie Fund Manager Hawksmoor Fund Managers
At the most basic level , the minimum objective of any investor is to deliver a positive return after the impact of inflation and charges over the long run . Elevated valuations in many traditional asset classes undermine the probability of achieving this goal in the future . In this article we explore how this problem has evolved , and why investors should adopt a more innovative and differentiated approach to portfolio construction in order to meet their objectives going forward .
The traditional ‘ diversified ’ multi-asset portfolio The traditional 60 % equity 40 % bond ( 60 / 40 ) portfolio has been a mainstay of portfolio construction for decades , and on most measures has been an unequivocal success story . Listed equities have delivered inflation-busting growth whilst government bonds have acted as an effective hedge to equity risk . Many multi-asset investment strategies continue to allocate using this traditional framework , including passive solutions . Such benchmark-driven and market capitalisation weighted approaches to asset allocation can , however , result in concentrated underlying exposures with a significant bias to US large-cap equities and developed market government bonds . Both of these asset classes have enjoyed protracted bull markets , delivering returns in recent years well in excess of long-term averages , which has resulted in ever higher valuations .
Government bonds – more risk , but less return Turning to government bonds first , yields have fallen steadily over the past 40 years and remain close to historic lows . Investors in 10-year UK government debt , for example , receive a paltry nominal gross redemption yield of 1.15 %, a level of return that fails to satisfy that most basic of investment objectives . The picture is true elsewhere with US , European and Japanese sovereign debt all delivering negative yields when adjusted for inflation . As yields have fallen there has been a concurrent increase in the interest rate sensitivity of bond markets , which for investors effectively means less return and more risk . The margin of safety associated with owning the asset class today has compressed significantly , with any income returns overwhelmed by the capital losses associated with even the smallest of increases in yield . Perhaps more importantly , the efficacy of government bond yields as a hedge to equity risk is also undermined by today ’ s starting yields , with the bond maths demanding nominal yields would have to go deeply negative from here to offset future equity corrections . Interestingly , in the pandemic-inspired equity drawdown of February and March 2020 , government bonds in already negative yielding markets like Japan and Germany actually lost money during the peak to trough equity fall .
Equity markets – priced for perfection If the low returns and diminished hedging qualities of government bonds are posing problems for traditional asset allocators , then so too are prevailing equity market valuations which , following a bull market that has vastly outpaced underlying corporate earnings growth , currently stand at some of the most extreme levels in history . We believe that many equity markets are currently priced for perfection and offer little in the way of margin of safety . We fully accept that valuation is not a particularly good market timing tool but observe the empirical data that suggests that valuation is the key determinant of subsequent long-term returns .
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