Tough year ahead

As you read this article I expect many will be reviewing the worst month for investment portfolios in many years.

At the time of writing, conventional diversified balanced and growth portfolios (with around 60-80 per cent in listed equities and property) were down around 10 per cent for January so far, with just over a week to go.

Rolling one-year returns for such funds/portfolios are now clearly negative and the financial year to date is now also showing high single to low double digit negative returns. More aggressive fully invested equity/property and geared portfolios are obviously doing significantly worse, especially over the shorter periods.

While the speed and the concentrated nature of the decline has been a surprise and has clearly caused significant stress, the fact that markets are reversing is not.

And while many commentators have been calling for a move to lower returns, they fail to mention that it is rare for markets to neatly revert to low but still positive returns.

Rather, lower ‘average’ returns typically occur because the oversized positive returns of previous years are replaced with serious negative returns over following periods (which may be years or shorter in crash scenarios).

This reversion of long-term returns towards longer-term averages is what bear markets are all about.

While there are still many in denial, the evidence suggests many mainstream assets are now well into a bear market.

Global and local property trust markets have now fallen 30-40 per cent from their highs, which certainly classifies as a bear market.

While the US, Australian and many global share markets are down more than 20 per cent from their highs, this is hiding some sectors that have done considerably worse and arguably been in a bear market since early/mid last year (for example, most financials).

No bear market goes down in a straight line and markets may well have rallied strongly by the time you read this, perhaps on hopes that US fiscal stimulus and further rate cuts can resurrect the sagging US economy and stock market.

A case can also be made that the resources story still has legs if the US recession doesn’t substantially impact global growth and commodity prices, and this could help support our market in the short/medium term.

However, even if this turns out to be the case, the current weakness is almost certainly not just a normal correction that will be quickly forgotten with share and property markets making new highs in the near term. There are serious imbalances in the global financial system being unwound and they will have ongoing and significant economic and financial impacts.

Indeed, even if markets perform better than expected from here, I expect the next year will still be a very difficult year for the local (and global) investment industry as the fallout from recent events impact more broadly.

Below I provide my view on some of the issues/trends that I believe will dominate this year.

Firstly, I believe there will be a reassessment of the role of gearing into investments.

I’ve always held the view that only relatively few clients have the tolerance to handle high levels of gearing.

Instead, in recent years it seems many advisers (and investors) have come to the view that almost every investor in the accumulation stage (and even some beyond that) is suited to aggressive gearing using home equity loans and/or margin lending. The current turmoil will show that they aren’t, and I suspect many geared portfolios will be heavily cut back or unwound at significant losses. Related to this, while contracts for difference can have a role for some sophisticated traders, it seems they have been heavily used by amateur investors to even more heavily leverage long positions in stocks.

Those product providers eagerly creating new products to allow self-managed super funds to gear into shares and property are likely to find they prove less popular than they currently expect.

Many structured products will be seen to have failed, especially for those investors who geared 100 per cent into them.

Already, some of the dynamically protected funds investing in mainstream assets have been forced heavily into cash.

While, theoretically, investors can wait the full-term (typically five years or so) and receive the initial amount invested back, this provides little comfort if they have borrowed all the money and are paying up to 10 per cent per annum interest in the meantime.

Many will just cut and run where possible with short-term losses and therefore not benefit from capital protection in any case.

Other gimmicky structured products that invested a significant portion of the funds in equity call options and offer only limited capital protection at maturity are also set to disappoint.

Some of the better-structured products with exposure to truly uncorrelated assets will fare better despite the high fees, but the appetite for most structured products (especially gearing into them) is likely to slow dramatically, partly because the cost of internal and external leverage has increased.

The strategic/set and forget approach to asset allocation, involving continuous high weightings to growth assets, will once again come under question. Not because it doesn’t work in the very long-term of 15-20 years (it mostly does), but rather because most unsophisticated investors consider the long-term as much shorter than this (usually no more than three to five years) and many don’t have the tolerance for even shorter periods of significant negative returns.

It is true that some groups do a much better job than others in educating clients about long-term investing and encouraging them to persevere through market cycles.

The willingness to adjust asset allocations over time should be seen as more about risk management than short-term market timing.

For example, it just didn’t make sense to continue to hold very high levels of listed property trusts (or add global property exposure in recent years as new funds came out) after a period when returns had already been so high and valuations had become so expensive.

In addition, many clients will have actually gone into the recent weakness with property and equity investments above their own strategic asset allocations, as they typically only periodically rebalance (and some neglect this completely) to take profits from the better performing investments and top up those that have underperformed.

As part of this reassessment of asset allocation, many advisers who have to date only invested in mainstream assets will be inclined again to look at the role of alternative assets and strategies.

While some alternative assets or individual alternative fund strategies have clearly not been immune from weakness, a well-diversified portfolio of alternative investments has proved a valuable diversifier.

For example, well diversified/market neutral fund of hedge funds have held up well in the current period of equity market weakness, and some other areas such as managed futures, gold and commodities have actually made money since equity markets have peaked.

Advisers clearly need to approach alternative investments carefully.

Ideally, they need a spread of alternatives that are carefully and professionally selected. Alternatives shouldn’t just be used as a reaction to bad markets only to be abandoned once equity markets are doing better. Rather, they should be an essential part of building quality long-term portfolios that can help provide clients a better ride through difficult periods such as now.

Difficult markets do bring excellent buying opportunities for the medium term, although one needs to be selective and patient.

It’s not a time for panic, although it is a good time to be taking advantage of others’ panic resulting from irrational or forced selling.

In the listed investment company area, which we follow closely, we have seen a number of examples of indiscriminate selling, probably margin lending-driven, driving already large discounts to net tangible assets much wider, including some cases where the underlying assets have largely held their ground or fallen only modestly.

Of course, to take advantage of these opportunities you do need to either retain some cash, have the ability to switch from other assets or make use of unused borrowing capacity (for those few clients who have the tolerance for gearing). And you should not expect the benefits to arrive from such buying immediately.

There will be a reassessment of what really are ‘defensive assets’.

There will be recognition that historically defensive assets at very high prices (like property trusts until recently) are clearly not defensive.

There will be recognition that a high yield does not necessarily make an investment defensive when that yield is not well supported and/or has been financially engineered through high debt levels or use of derivatives.

There is no point in obsessing with yield when that yield can be wiped out more than five times by the move in capital, as has recently occurred with listed property trusts.

While many market losses may well be recovered eventually, I would expect a number of product failures (in addition to the problems of some structured products mentioned above).

Some will be driven by a major liquidity mismatch between the terms offered to investors and the nature of the underlying assets held.

The risks of heavily internally geared products will be exposed.

Some funds will fail simply because the managers made some very poor decisions.

There will be a return to favour of some of the better value and absolute return oriented managers, who had begun to be abandoned by advisers and investors in recent years.

These problems (and perhaps the regulators) will inspire advisers and dealer groups to have a closer look at how they select investments and build portfolios for their clients.

Those advisers building portfolios of shares, fixed interest and property trusts directly will need to re-examine whether they have sufficient in-house skills, or access to these skills, to do this effectively. (And simply accessing broker research is probably not enough.)

More fund problems and failures will raise similar issues for those building portfolios using managed funds, especially at a time when the value of external research house recommendations are already being questioned following issues from last year.

I would expect more to turn to professionally run multi-manager products for at least a core of their portfolios, including those multi-manager funds that include alternative assets and strategies to complement conventional assets.

Even platforms will be forced to answer the question of whether they are in the investment selection business or the administration business.

If they persist in doing preferential deals that influence the flow of funds towards particular fund managers and specific products, they had better be sure those products are well researched and right for the investors using their platform (especially in super, where the trustee is responsible). And again, simply relying on external research houses may not prove adequate.

That brings us to the research houses.

Apart from the problems they are already facing, more fund failures of highly rated products are likely, which will open them up to further scrutiny.

No one expects researchers or any investor to be right at all times (especially in difficult times such as those we’re experiencing now), but these problems and the poor performance of many portfolios built simply from selecting rated products with limited consideration of portfolio construction issues will lead to further scrutiny of the research houses’ levels of skills, their remuneration models and the focus on product issues to the relative neglect of portfolio construction and asset allocation issues.

The regulators will be more active, with a new Government also keen to improve the reputation of the Australian financial services industry. They will have their hands full and one hopes they focus on key structural issues rather than the typical reactive approach to particular crises.

The listing of financial services businesses and fund management companies is likely to dry up given the de-rating they have already suffered and the likely tougher times ahead.

Listing plans for such businesses will have to wait for the next cycle, which could well be some years off. Some might count it as a blessing, as some existing listed fund managers and other financial services business may have a particularly tough year ahead dealing not only with unhappy investors but unhappy shareholders as well.

After four to five years of good times and the fact that Australia largely sailed through the early 2000s tech crisis, it was inevitable that a difficult period was looming for investment markets and the investment industry. It’s just that no-one knew the exact timing.

But while many problems are expected this year and beyond, quality financial planning businesses that survive through this period will probably emerge more robust then ever.

Some fund managers will fall by the wayside, while those with a unique value proposition will standout and build market share.

Investors who can keep their eye on the long-term but use difficult markets to build better portfolios will be well-positioned to accumulate wealth, albeit requiring more patience than they have become used to.

Still, it is likely to be a stressful period for all in the investment industry: advisers, research houses, platforms, fund managers and investors.

This year will be a year when the industry is truly tested and its long-term value subjected to enormous scrutiny. Some will fail that test.

Dominic McCormick is the chief investment officer at Select Asset Management .