Hoping for the best and about to get the worst

In the current environment, the conventional buy and hold investment portfolios recommended by many advisers and research houses (often via model portfolios) would perhaps be better described as ‘buy and hope’. Many of these may be poorly suited to the challenging investment environment emanating from the global financial crisis (GFC). While ‘this time is different’ is a very dangerous phrase in the investment business, for once I believe it is appropriate.

What do I mean by a conventional buy and hold portfolio? Typically, these involve adopting largely ‘set and forget’ long only allocations to the major mainstream assets classes (anchored to a long-term strategic asset allocation) and using lower cost passive or large, brand name, benchmark focused funds to implement these allocations. I am obviously generalising to some extent as there are varying degrees of adherence to the typical conventional approach.

The ‘hope’ element is that these portfolios require a ‘normal’ environment dominated by multi-year bull markets, and high returns from equities in particular, to deliver good results and acceptable risks to investors. For better or worse, such portfolios are almost totally hostage to broad market returns.

For Australian investors, these ‘buy and hold’ portfolios worked well for most periods through to 2007, and certainly still appear reasonable looking backwards using longer-term historical returns and risks (even including the last two years). Further, this approach is deeply embodied in the conventional theory and practice of investment management as developed over the last 40 years or so.

This conventional approach therefore offers two attractive attributes for advisers (if not their clients). Firstly, applying it is unlikely to result in advisers being sued (at least while they retain the conventional wisdom) and, secondly, they provide a simple scapegoat for advisers when portfolios don’t deliver for clients: the markets. Advisers can never be responsible for client losses because they can’t control markets, so the argument goes.

In this worldview, where the major broad markets are the primary factor driving investor returns and risks, minimising investment costs becomes the predominant priority, and this has encouraged the take-up of passive funds, including exchange traded funds more recently. Industry pressure to deliver simple, low cost portfolios using major asset classes has been accelerated by the Cooper Review’s My Super proposals.

The downside

What is the downside of such an approach? Well, a strong case can be made that this conventional ‘buy and hold’ approach is flawed, at least in the current and expected investment environment emanating out of the GFC. Lower costs are a desirable goal, but not at the expense of everything else.

We believe that this conventional approach and the associated obsession with low cost results in portfolios that are:

• too restricted to mainstream assets only;
• too static in asset allocation;
• too dependent on equities (especially long only and index focused);
• too dependent on Australian assets;
• too restricted in the type of vehicle/strategy to access asset classes; and
• too backward looking in asset and manager selection.

I have covered most of these issues in previous articles and believe these flaws in the conventional approach are being accentuated by a more difficult investment environment. Advisers adopting a conventional ‘buy and hold’ approach may therefore be running a significant risk of failing to meet the true investment objectives of their clients (and the Cooper Review recommendations could end up locking a multitude of ‘disengaged’ superannuants into near certain disappointing returns).

When economic and valuation trends are supportive, buying ‘the market’ can work well, as much of the last two decades shows. However, in a world where economic growth is likely to be less robust and more volatile, and valuation trends less favourable, just ‘buying the market’ is no sure recipe for success. Deleveraging in the Western world is likely to weigh on growth and valuations for an extended period.

A more volatile environment is also likely to increase risk premiums (ie, lower valuations) and some of the factors that helped returns over recent decades no longer apply.

For example, having fallen from around 15 per cent in 1980 to as low as 2 per cent at the end of 2008, the valuation boost (ie, higher price/earnings ratios (PEs)) from falling US 10-year bond yields is largely a spent force and they are more likely to be a headwind to equity valuation in the years ahead. A period of gradually falling market PEs (admittedly to what could end up as very cheap levels) cannot be ruled out. Sovereign bonds themselves hardly look enticing as an asset class from these low yield levels given the deteriorating fundamentals (deficits, public debt/gross domestic product) in many Western countries.

Thus, it is relatively easy to make a case that good returns from a buy and hold approach will be difficult to achieve in coming years. But haven’t we heard this before? How many times were we told through the 1990s and 2000s that future returns from mainstream assets would be lower, yet until 2007 they generally kept delivering in double digits and above long-term historical levels. What is different now?

I think the GFC has been the real game changer here. It signals we are at or near the endgame of decades of credit fuelled economic and asset growth and the beginning of a period of deleveraging and more subdued but volatile growth, where resultant risk aversion drags on valuations and returns. While some governments are attempting to hold off this endgame by expanding debt levels themselves, this response will itself eventually have significant negative implications for markets.

Further, the GFC has shattered the perception that the business cycle had been largely abolished, which was a significant justification for gradually higher PEs and lower risk premiums across other asset classes (eg, property and credit).

Of course, there will be plenty of ups and downs over months and years (providing trading/short-term opportunities), but don’t be surprised if broad asset classes make relatively little overall progress on a three to five-year view from here. Within markets there will be good opportunities for value oriented active investors, but this is not an environment where a more passive buy and hold approach across broad asset classes is likely to be well rewarded. Just look at the US, where returns from a buy and hold portfolio skewed to equities are still negative after more than a decade. There, several commentators are already pronouncing the buy and hold approach dead. This debate is just beginning here.

Any truly forward looking investor should therefore at least consider the possibility that the future investment environment could be very different to the decades leading up to 2007 as the world struggles to work through the imbalances leading to, and resulting from, the GFC. Buy and hold could end up a poor strategy no matter how low you can get investment costs, and how much simplicity or liquidity you have.

A more flexible approach

Fortunately, ‘buy and hope’ is not the only way. There are more diversified but flexible approaches that can be better placed to achieve returns and preserve capital in a more difficult environment.

Characteristics of this more flexible approach include:

• a more flexible approach to asset allocation based on changing valuations and scenarios;
• forward looking assessment of risk and return, not based on historical numbers;
• selection from the full investment universe, including alternative investments;
• the use of strategies/approaches within asset classes to increase returns and/or decrease risk in addition to traditional long only (eg, long short, option based or listed funds);
• a contrarian approach to both asset allocation and investment selection seeking value and neglected opportunities; and
• a willingness to hedge tail/black swan risk to protect the portfolio from extreme scenarios/risks.

However, there should be no illusions here. This is no simple silver bullet solution. Implementing this approach is very difficult and it comes with no guarantees. It relies on the subjective judgments of fallible (but hopefully skilled) human beings. It is certainly still dependent on market returns to some extent (albeit a broader range of markets) and it is likely to be more costly than the conventional approach. It may also be less liquid and more complex at times.

This approach offers plenty of scope for mistakes to be made and periods of poor absolute and relative performance will occur. I’m reluctant to label this a better approach because done badly it would be worse than the conventional approach, perhaps much worse. But in the challenging investment environment we expect such an approach offers the best chance, perhaps the only real chance, to achieve reasonable returns with acceptable risks for investors.

The research and asset consulting community has taken some steps towards this more flexible approach in recent years (more dynamic asset allocation, introducing alternative investments, etc), but these have been tentative, as moving this way is an implicit rejection of the conventional buy and hold portfolio approach they have championed for decades.

Reluctance to move down this path has also come from the response to the GFC by many investors and advisers in rejecting some of the very investments and strategies (mainly alternative investments) that can be important building blocks of this more diversified and flexible approach. While it is understandable that some investors have rejected certain asset classes and investment strategies that disappointed during the GFC, the risk is that in the quest for simplicity and low cost, they have thrown out the good and the bad amongst these and in so doing are inhibiting their ability to build and/or understand more robust portfolios for the current environment.

Alternative investments

When it comes to alternative assets and strategies, it is clear that some advisers, investors and fund managers (and we were not immune) embraced certain alternative investments without fully understanding their risk/return dynamics in different environments. Of course, the relative newness of some of these alternative areas and their rapid development in recent years made deep assessments difficult.

For many investors and advisers, a sour attitude to alternative investments was also inevitable given the aggressive activities of some alternative investment managers who were primarily interested in selling as much product as possible (often in structured or highly geared form), rather than demonstrating how alternative investments could be used as part of a well diversified portfolio and as a complement to traditional assets. Given this, and the liquidity issues emanating from the GFC, it is no surprise that most of these firms are no longer around or have been forced to restructure their businesses dramatically.

Nevertheless, these experiences need to be put aside to allow rational and objective assessment of the role of alternative assets and strategies in more flexible portfolios. Given the need to consider every potential value adding investment to build more diversified portfolios, this is no time to be excluding assets or strategies based on kneejerk, emotional grounds.

The key problem with the conventional buy and hold approach is that its primary objective — to provide investors with market returns — requires total (and in my view an irrational) faith that those market returns will be reasonable over time and the risks acceptable to investors. If they are not, this approach may well achieve its objectives but totally fail those of investors.

We believe a better way is to focus on attempting to achieve the actual objectives that most real-world investors actually have. That is, to make money versus cash/inflation and to avoid major, especially permanent, losses. This is not easy, but at least this more flexible approach is consistent with what clients want and need in a very challenging investment environment.

The simple, low cost, buy and hold portfolios that are currently favoured and which may make both advisers and clients initially feel good are, in our opinion, exactly the wrong type of portfolio for this environment. Further, as it becomes increasingly easy for investors to achieve market returns through ETFs and other passive vehicles, there is the valid question as to what value an adviser pushing these buy and hold portfolios is adding.

It is worthwhile highlighting that the discussion above is not some remote theoretical criticism of the buy and hold approach while suggesting ‘pie in the sky’ alternative approaches far removed from practical reality. In fact, the principles outlined above have been the basis for the multi-asset, multi-manager portfolios offered by SELECT for almost eight years and, in large part, by a small number of innovative managers globally, such as GMO. Over that (often difficult) period it has been demonstrated that, despite higher fees, this more flexible and diversified approach can achieve good absolute returns, outperform the conventional approach and, importantly, do so in a way less reliant on market returns.

One of the necessary ingredients for embracing such an approach is the willingness to question and challenge conventional investment wisdom. Unfortunately, this attitude is in short supply in the investment industry. Much more common is the tendency of the investment industry’s conventional and ‘group-think’ driven solutions to deliver serious disappointment to clients. I suspect the buy and hope approach (and its associated obsession with low cost to the detriment of other vital investment issues) will be the next course to deliver this disappointment. Advisers and investors should at least know that there are potentially healthier and more fulfilling (if more expensive) courses on the menu.

Dominic McCormick is chief investment officer at Select Asset Management.