Bonds (corporate and government debt) have been a haven for those seeking income as an alternative to cash. There has been a perception that bonds are nearly as safe, and perhaps there is good reason for thinking so, based on the last 30 years.
But for some time, we have expressed concerns over the ‘bond bubble’. The reality is that the party for bonds is not sustainable and will come to an end, we just don’t know when. What we do know is that we don’t want to be around when it happens, because there will likely be pain for those still invested.
The point of inflection is very close; several people have expressed concerns, and this is often a time to take notice. There are reasons why this is happening; QE is being reversed, and inflation and interest rates are rising. These factors are not good for bonds.
Within our portfolios, and for those seeking cash plus returns, we have turned to alternatives. However, over the last 18-months, the returns have been disappointing. In this blog we want to explore why we went down this route, and whether this is still the right place to be.
Traditional investing
Traditional investing was previously very simple; much of which seemed to focus on risk, which was defined as a loss of capital. We would argue that there is a problem with the perception of risk when it comes to investing.
For example, if an investor had invested everything in Carillion shares, then the collapse of the company would have meant they would have lost everything – that is a permanent loss of capital. If, they invested in a fund that held 5% in Carillion, then although the money in the short term would go down, they would hope over time that the remaining assets would make up the loss. That we would argue is volatility and is something very different.
Volatility is the movement in the value of the investments daily. For some, sharp falls in prices can be extremely uncomfortable. The problem is that to protect on the downside (i.e. when the market falls) there must be some trade off at times when the market is rising sharply. Often investors want all the upside and none of the downside – the reality is that this can’t happen.
This is where portfolio construction comes into play. Bonds tended to have much lower volatility than equities and based on the last 30 years, delivered positive returns over most periods. If markets fall these don’t tend to fall as far as equities but on the flipside, they don’t tend to go up as much. Therefore, to get some of the benefits of equities and protect on the downside, investors have moved along the asset curve to a place where they are comfortable.
For example, investors perhaps had a 60% bond exposure and 40% equity exposure where they are cautious, and perhaps 10% bond exposure and 90% equity exposure where they are prepared to accept more volatility. The level of volatility can move to match the client’s comfort level.
This has worked for many years but in an environment where bonds might start to deliver negative returns, the question arises as to whether this traditional approach is right for the future.
A different approach
In 2008 Standard Life launched a product which targeted a return of 5% (gross of charges) above cash. They were not the first but perhaps it is the best-known strategy. Investing from launch in 2008, until end of 2015 investors would have thought that Standard Life had unlocked the secret to delivering the holy grail of investing.
What this strategy did was two-fold; firstly, and importantly it kept volatility low, and secondly it targeted a positive return over a rolling 3-year period.
It appealed for several reasons; to cash investors tired of near-zero interest and erosion of asset values through inflation, and for those constructing portfolios it seemed a good alternative to bonds, especially over the longer-term.
Like any successful strategy this can also be its undoing. Standard Life, and others attracted a considerable amount of new investments as people turned to them as an alternative source of return. There has also been a flurry of similar products appearing in the market to capture this “rich” source of revenue.
We have met several managers offering such strategies, each with varying nuances. Some are like Standard Life’s idea-based strategy, some use dynamic asset allocation (moving between different assets (bonds, equities etc) depending on their short-term view) and others use hedge fund type strategies. What they all seem to have in common is the aim to target a return above cash and reduce volatility.
The challenge is that over the last 18-months these strategies have struggled to deliver on the targeted returns. This of course brings into question whether these strategies were a flash in the pan, or the underperformance is a short-term blip.
What are we trying to achieve?
When it comes to portfolio construction the key to this is volatility, and how we reduce it without having direct exposure to bonds. Looking across all these strategies, most have kept volatility low, and close or lower than that of bonds. Even in a period of relatively poor performance they have delivered on one stated aim.
In meetings with fund managers they always point to this, but they want to shy away from the elephant in the room; performance.
These strategies are “sold” on their target returns and yet very few managers want to talk about it (they don’t guarantee the returns I would add). The reason being is that many of the strategies have not hit their target return levels. This being a period of 18-months when equity markets have raced away. Investors rightly have seen markets go up 20% plus, and yet many of these strategies have struggled to deliver anything near 5%.
During this period and especially in 2017 there was very little volatility in markets, and they kept edging up. Clearly this market environment disrupts these strategies which has contributed to the poor performance.
It is worth remembering that although these funds target a positive return, there will be periods when they go down and although they want to achieve the smoothest ride to those targets, it is simply not possible to do.
In hindsight it is probably fair to say that over the last 18-months a 5% target return was a tall order, but no-one could have foreseen this. The question is once volatility returns to the markets, can these funds deliver?
That is a million-dollar question. We believe that so much has been invested in these strategies that this period will reverse but like everything, we don’t know when.
What about the cash argument
Interest rates in the UK can only go up, but there is no expectation that this will be at a level that will make holding cash an attractive long-term investment. It could be five years before we get to a normalised rate, and that could be 2% to 3%. A lot lower than the 5% we have seen in the past.
But if investors are using these strategies as an alternative to cash, the last 18-months has not been kind to them. However, even a slight improvement over the next 12-months could quickly reverse this.
Like any investment, it is about understanding the motives for holding it. If this is an alternative to cash and a long-term investment, then waiting may be the best option. Equities can obviously be used as well, which may increase volatility but eventually create returns.
Conclusion
Fundamentally, we believe the bond’s best days may have passed. We use Absolute Return strategies within portfolios to protect on the downside but capture some of the upside. These are not bonds but they can share their characteristics, such as volatility which allows us to identify strategies that could be blended together. The last 18 months have not been kind to these strategies, which has been compounded by a period of extreme market returns.
But, for those using these strategies it should never have been about capturing the full market returns because as quick as rise they can fall (1987, 2001, 2008, 2011, 2016 etc). These strategies have therefore achieved the target volatility but not the performance. To highlight further, when there are 20% returns in the market and 2% return on these strategies it seems bad. But if the markets fall 20% and these strategies are slightly positive, slightly negative or flat it would seem quite different.
We therefore believe these strategies still offer downside protection, control volatility and can be used as an alternative to bonds. We know that performance is an issue but as volatility comes back into the market this should start to reverse the poor run of performance. For those in portfolios they should capture some of the equity upside due to the spread in holdings.
Note: This is written in a personal capacity and reflects the view of the author. It does not necessarily reflect the view of LWM Consultants. The post has been checked and approved to ensure that it is both accurate and not misleading. However, this is a blog and the reader should accept that by its very nature many of the points are subjective and opinions of the author. Individuals wishing to buy any product or service as a result of this blog must seek advice or carry out their own research before making any decision, the author will not be held liable for decisions made as a result of this blog (particularly where no advice has been sought). Investors should also note that past performance is not a guide to future performance and investments can fall as well as rise.