Navigating a slow growth market environment
BY Bert Clark, CEO, the Investment Management Corporation of Ontario | November 11, 2019
Navigating a world of low government bond yields and long-term expected returns on other asset classes is a major challenge for investors. The yield on the U.S. 30-year Treasury reached an all time low of 1.95 per cent in August and the cyclically adjusted price-to-earnings ratio for U.S. stocks sits at around 26, which is significantly above its long-term average of around 17. These conditions rightfully make investors nervous because starting valuations are one of the better predictors of future returns. Paying a higher price makes it more likely that long term returns will be lower.
So, what can investors do in this kind of environment?
There isn’t a silver bullet solution to overcome potentially lower returns across the board. Investors should not let nervousness around valuations distract them from the investment fundamentals that have been proven to optimize results over the long term.
Don’t behave as if you can accurately predict the future
While valuations are high today by historical standards, they were also high five years ago and they may continue to be so. The future cannot accurately be predicted. Any investor who assumed an imminent reversion to historic valuations five years ago and exited U.S. equities would have missed a 65 percent increase in the S&P 500 (as measured in U.S. dollars). Similarly, any investor who assumed that long term interest rates were set to rise to historic rates five years ago would have missed out on the 34 per cent total return of Canadian long bonds over that period.
Be cost conscious
Costs are one of the few things investors can reliably control and they have a significant impact on net returns. In fact, many investors pay fees that exceed their net value add. In a world of potentially lower absolute returns, costs will matter even more than in the past.
Investors that want to access market segments where net value add is rare, should consider lower cost, passive strategies. Large organizations can reduce costs in private asset classes through internalization or better partnering arrangements. This might include eliminating additional layers of managers; reducing and focusing manager rosters; negotiating preferential fee arrangements; and co-investing alongside external managers on a no-fee basis. Smaller institutional investors should consider pooling resources to reduce costs and to access some of the benefits that are typically only available to larger investors.
Ensure you have adequate liquidity
Most investors have portfolios that are tilted towards growth assets, such as equities and credit. Generally, these assets generate higher returns over the long-term, compared to assets like short term bonds. But growth assets are subject to greater near-term fluctuation in value. In order to benefit from the higher returns of growth assets over the long-term, investors must be able to weather fluctuations in value in the near term – and avoid selling during down markets. The key to doing this is having adequate liquidity to meet ongoing cashflow needs and, in an ideal world, enough liquidity to be a buyer when markets are down.
Avoid outsized asset allocations
Asset mix is the most important decision an investor makes. More than any individual investment within an asset class, an investor’s asset mix determines its overall risk and return. Unfortunately, there is no methodology that allows investors to accurately predict the future returns and correlations of asset classes and to scientifically construct their portfolio. The past is instructive, but it only points to broad tendencies and relationships, not hard and fast rules.
Given the power of asset mix decisions, and the lack of reliable predictive models, investors should make sure their portfolios are well-diversified across a broad set of asset classes, and they should avoid making big asset class bets that are dependent on any single asset class. Investors are often tempted to have a defining aspect of their portfolio, such as a large “overweight” to one asset class that reflects a particular world view. Predicting which asset class will outperform broad market expectations is hard to do and can have large negative impacts on the total portfolio if you are wrong. It is better to prioritize building a resilient portfolio that ought to produce acceptable results under the widest array of future conditions than it is to build a portfolio that is highly dependent on a few narrow outcomes.
Focus on market segments where you have, or can develop, an advantage
Outperforming the market is difficult. In some segments it may not be worth the effort and investors should focus on those areas where they have the greatest chances of success. Generally, this means pursuing market segments where they have, or can build, an advantage.
Investors can have an advantage when they develop competitive expertise and where they have differentiated preferences from other investors in the market. For example, they may have a longer investment time horizon, greater tolerance for complexity or illiquidity, unique operational expertise or willingness to be directly involved in an investment. Having an actual advantage is a much better basis for pursuing outperformance than assuming you will regularly develop superior insights.
In a world of potentially lower absolutely returns across the board, net value add will matter more. Investors need to be focused on those market segments where the likely results justify the effort and cost.
Today’s capital markets are highly competitive and there is no silver bullet solution that will enable investors to overcome potentially lower-for-longer returns, if that is what is in store. Instead prudent investors should focus on the broad fundamental strategies that have been shown to optimize investment results over the longer term.