June 2013
For professional investors only
Talking Point
Achieving a real return of +5% in the
current environment
by Simon Doyle, Head of Fixed Income and Multi-Asset
Low interest rates and bond yields, contracting credit spreads and uncertainty about equity markets
are currently challenging investors. This article outlines our thinking around these issues and
highlights how we expect to use the current risks and opportunities in markets to achieve our
objectives.
Understanding our objectives
At the outset, it is necessary to clearly understand what we are aiming to achieve. The Schroder
Real Return Fund has as its investment objective a target rate of return of 5% above Australian
inflation over rolling 3 year periods, whilst seeking to minimise path and drawdown risk, and
maintaining a high level of liquidity.
There are several important elements of this objective that warrant elaboration.
–
We are not seeking to maximise the return on the portfolio for a particular level of risk. Instead,
we are seeking to maximise the probability of achieving the return target (5% real), and, in
effect, to minimise the dispersion of outcomes around this number.
–
The 3 year timeframe is important. Sensible investment decisions can take time to play out and
our research suggests that 3 years is generally a sufficient interval for this to happen. In the
shorter run there may be greater variability around the target return (both to the upside and the
downside). Equally, risk premia are dynamic (as is our investment process) and this will drive
changes to portfolio strategy, sometimes significantly, throughout this investment horizon. In
other words, our strategy should respond over the course of our investment horizon to changing
return expectations by recalibrating the portfolio to our objectives.
–
There is an important asymmetry in the risk equation, that is we recognise that preservation of
capital is critical in its own right but also to ensure the portfolio is well positioned to exploit
opportunities that markets present after periods of volatility and disruption. It is this asymmetry
that is particularly significant in framing our investment decisions, especially in the shorter run.
More importantly it dictates what we won’t do, and that’s to take on more risk than we deem
appropriate in the shorter run simply to lift expected returns. This is particularly relevant in the
current environment of low and declining interest rates and the encouragement that investors
are getting to allocate more capital to risk assets to boost portfolio yields, irrespective of the
associated price risk. If this means that our shorter run returns fall short of a 5% real return “run
rate”, then so be it. It is our belief that pushing the envelope in the shorter run will only make our
medium term goals more difficult to achieve.
Matching investment strategy to the objective
The current investment strategy of the Schroder Real Return Fund must be viewed against all
elements of the investment objective described above. The starting point in our investment process is
Issued by Schroder Investment Management Australia Limited
123 Pitt Street Sydney NSW 2000
ABN 22 000 443 274 Australian Financial Services Licence 226473
June 2013
For professional advisers only
our forecasts for risk and return for the various major asset classes1. These forecasts are important
as they provide a relatively objective starting point for determining where risk should be allocated.
Our latest2 forecasts shown in figures 1 and 2 are presented firstly comparing expected returns to
risk (proxied by the probability of a negative return in any one year) and secondly by comparing our
forecast returns with an estimate of the dimensions of any potential downside as proxied by our
estimate of the 95% VaR. In other words, if our forecasts are wrong and we do get a negative return,
how bad could it be.
Figures 1 and 2. Return and risk forecasts for the Schroder Real Return Fund as at 31
May 2013
Expected Return v Probability of Loss
Expected Return v Tail Risk
9
10
Aust
Equities
Aust
Equities
9
8
8
Global
Equities (H)
7
6
Aust High
Yield
Aust High
Yield
Global High
Fixed
Yield (H)
Income
5
4
3
Cash
Global
Equities
(H)
Fixed
Income
Cash
7
6
5
4
Global High
Yield (H)
3
2
2
1
1
REIT
REITs
0
0
20
40
Prob. of loss in any 1 year
60
10
0
-10
95% VaR
-20
Expected Return (3yr, % pa)
Expected Return (3yr, % pa)
10
0
-30
On the basis of these forecasts, equities are clearly the only broad asset class that, based on current
valuations, have the potential to achieve a standalone return commensurate with 5% real over the
next 3 years. Furthermore, Australian equities offer the highest prospective returns on our
assumptions, mainly due to relatively high yields and undemanding valuations helped by recent
significant underperformance compared to other developed markets. At the other end of the
spectrum, prospective returns from Australian REITs look poor (we’ve got 0% pa over the next 3
years) despite the sharp falls in May as valuations remain stretched against a backdrop of “average”
cash yields. Bond returns are pedestrian reflecting low yields and tight spreads, compounded by the
potential mean reversion of current credit spreads implied by current low corporate default rates.
At this point it is important to emphasise that our forecasts are simply forecasts. This means that
despite our best efforts they are uncertain, and particularly so at present given the structural
difficulties faced by key parts of the global economy. This is why understanding the risk around these
return forecasts is important. While the risk of a negative return in equities may be seen to be similar
to that of fixed income (including higher yielding credit) on the basis of our current estimates, the
downside to equities is significantly larger (refer figure 2 above). Given our objectives reflect a clear
focus on downside risk management and the mitigation of this risk, this asymmetry is important.
To be confident in the consistent delivery of solid returns from equities, valuations of equities need to
be much cheaper than they are today. To our way of thinking, the cheaper valuations become, the
less risky the investment.
1
This includes factors such as skewness, kurtosis and correlation to ensure we fully understand the likely
behaviour of returns and the dimensions of the risks around them.
2
As at 31 May 2013
Schroder Investment Management Australia Limited
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June 2013
Forr professional advisers onlyy
How is th
his reflecte
ed in our current
c
inv
vestment strategy?
The curren
nt asset allocation of the Schroder Real Returrn Fund is as
a follows:
Figure 3: Schroderr Real Retu
urn Fund – Asset Allocation
A
as at 31 M
May 2013
A naive inte
erpretation of our curre
ent asset al location is that
t
it is a conservativee portfolio th
hat could
leave us sh
hort of the re
equisite 5%
% real return
n objective. However, this interpreetation assumes that we
e
do nothing to change the
t portfolio
o for the nexxt 3 years, stock
s
selection alpha iss 0%, and factors
f
such
h
as currencyy, curve, du
uration etc. add no valu
ue. Clearly this
t
is not th
he case.
The curren
nt investmen
nt strategy of
o the Schro
oder Real Return
R
Fund
d reflects a m
more complex set of
consideratiions outlined below:
–
The un
ncertainty around
a
our forecasts
f
(e
especially fo
or equities) is particularrly high give
en the
interplay between
n structural factors succh as broad based dele
everaging pllus unusuall and
aggresssive mone
etary policy measures d
dominated by
b QE. The probability of policy errror remainss
high w
which could trigger eithe
er deflation or inflation (yes both are
a equally likely in ourr view)
triggerring a structtural de-rating of risk a
asset prices.
–
A com
mbination of factors including QE, rrecord low cash
c
rates, demographhics and the
e herd
menta
ality have be
een instrumental in pusshing investtors into a broad
b
array of yield bas
sed
investm
ment, irresp
pective of th
he associate
ed price risk
ks. This has
s caused crredit risk pre
emia to
narrow
w, and, while not back to pre GFC
C levels just yet, until ve
ery recentlyy they were not too far
away. Credit quality has also
o diminished
d as cashed
d up yield ju
unkies cedee power bac
ck to debt
issuerrs. Look no further than
n the growth
h in covenant light loan
ns as evidennce. Likewise the trustty
“favou
urites” like REITs
R
have also seen ttheir prices pushed well above susstainable fa
air value.
This a
all means that risk in the
ese yield ba
ased assets
s is rising.
–
While local cash rates are un
ninspiringly low in an historical
h
context, the reelatively flatt local yield
curve (especially at the frontt end of the curve) and artificially low longer tterm yields implies thatt
if you don’t want to
t take risk in overprice
ed assets, then
t
cash is
s a better pllace to be on
o balance
Schroder Invesstment Manage
ement Australia Limited
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June 2013
For professional advisers only
than in duration (unless of course deflation emerges driving bond yields to new lows – more on
this later).
Bringing this thinking back to our current investment positioning we make the following observations.
–
The current exposure to equities (27%) will anchor decent positive returns at a portfolio level
should equity markets perform at or above forecast, but in the event that the factors outlined
above derail the equity recovery, then the negative impact on returns can be contained. It is
worth bearing in mind at this point that a 27% exposure to equities means equities still account
for over 50% of the variability in portfolio returns.
–
The flip-side to this is the cash exposure (30%) which has broadly 3 roles in the portfolio:
o
as a store of value against what we deem to be tactically risky markets (we won’t get
rich, but we won’t lose money on this exposure either);
o
as an inflation hedge (our research indicates that cash is one of the most effective
hedges against an inflation shock as central banks move to tighten monetary policy to
contain inflation); and
o
as a call option over future opportunities generated by market volatility and mis-pricing.
By maintaining liquidity in this way we are well placed to buy assets as valuations (and
risks) change, minimising the impact that big drawdowns in asset prices can have.
–
We have maintained a relatively broad exposure to a variety of credit assets. This is because we
continue to see some value in credit spreads (notwithstanding that we do expect volatility) but
also because we see credit as offering us some upside should risk assets continue to perform
without the downside risk of equities.
–
There are also two important features in our portfolio that are implicit within Figure 3 above.
–
o
Firstly, while we have no material exposure to government bonds, we do continue to hold
duration (at around 1.25 years) as we still see duration as offering us some protection
against recession and / or deflation. Likewise, we recognise that the ability of duration to
mitigate equity risk has diminished as yields have fallen, with our response being to have
less equity exposure than otherwise (rather than simply remove bonds / duration and in
effect increase risk);
o
Secondly, we have a significant exposure to foreign currency (mainly US dollars) in the
portfolio (15%). This is seen as both an important downside risk hedge, given the
correlation of the AUD to risk asset behaviour, and also as making a significant
contribution to returns over the medium term as it devalues towards a more sustainable
level. Note that 70-80 cents is our Purchasing Power Parity (PPP) estimate of fair value.
A fall to 80 cents over the next 3 years would, on the basis of current exposure alone
contribute almost 1% pa to returns.
On the basis of our assumptions, an asset mix that naively matched our return target would
require us to take more risk than we are currently comfortable with. The volatility of markets
during May 2013 clearly highlights how quickly the environment can change.
With these factors in mind we currently hold the following views.
–
We have sufficient risk to get close to target without exposing the portfolio to substantial
drawdown risk.
Schroder Investment Management Australia Limited
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–
We expect to deploy cash on market weakness to capture value in risk assets (both equities and
credit) but at levels that minimise downside risk potential.
–
We expect positive contributions from the following factors to contribute positively to returns:
o a structural weakening in the Australian dollar
o stock selection (especially in equities and credit)
o active management of overall exposure
Most importantly, overall, we see no reason why our CPI+5% objective can’t be achieved.
Disclaimer
Opinions, estimates and projections in this article constitute the current judgement of the author as of the date of this article.
They do not necessarily reflect the opinions of Schroder Investment Management Australia Limited, ABN 22 000 443 274,
AFS Licence 226473 ("Schroders") or any member of the Schroders Group and are subject to change without notice. In
preparing this document, we have relied upon and assumed, without independent verification, the accuracy and
completeness of all information available from public sources or which was otherwise reviewed by us. Schroders does not
give any warranty as to the accuracy, reliability or completeness of information which is contained in this article. Except
insofar as liability under any statute cannot be excluded, Schroders and its directors, employees, consultants or any
company in the Schroders Group do not accept any liability (whether arising in contract, in tort or negligence or otherwise)
for any error or omission in this article or for any resulting loss or damage (whether direct, indirect, consequential or
otherwise) suffered by the recipient of this article or any other person. This document does not contain, and should not be
relied on as containing any investment, accounting, legal or tax advice.
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