A conundrum for the conservative investor

Cash is facedown and bonds are off balance — what good are these duds as diversifiers?

Summary: Conservative investors are currently facing disappointing returns from traditionally defensive investments like cash and bonds - it's important to keep in mind returns are affected by broader macro conditions. Meanwhile, in 2015 a Morningstar investment conference saw 90% of attendees tip global and Australian equities as the top performers for the coming year - while fixed income and cash actually delivered top returns. However, standard definitions of growth and defensive investments are now harder to pin down - one option would be to track the progress of an international ETF.

Key take out: Professionals are finding it increasingly difficult to predict returns across asset classes - don't worry if you're finding it puzzling. 

Key beneficiaries: General investors.  Category: Shares.

It’s a particularly difficult time for conservative investors: For most people conservative equals defensive and defensive equals bonds or cash…but just now both those asset classes are presenting unexpected challenges.

• Defensives are meant to provide predictable capital returns, although distributions can be changeable. In contrast we know growth assets will never perform predictably, still in recent years yield from equities is strangely consistent.

• Cash is the ultimate defensive asset, with government bonds very close behind. 

There's a problem in this split, though: what is considered a "growth" or "defensive" asset can change over time, and the returns of all asset classes are affected by broader market conditions.

Before we look at some examples in detail, it’s important to make one outstanding point: Returns are not created in a vacuum - and using a short time frame of past gains as a way of picking investments makes it easier to get burnt. 

Bonds in the current climate 

Professional investors know all about bonds, including corporate debt, and hold them at respectable levels. Retail investors, however, just don’t care. Australia’s self-managed super funds have about 1.2 per cent of their wealth in fixed income…in  contrast they hold cash at 27.6 per cent. 

A consensus among retail investors might go something like this: When rates ultimately rise, bond prices will surely fall. And after tax and inflation, cash deposits pay almost nothing. Why bother with defensives at all?

With cash deposits in Australia paying around three per cent and passive bond funds offering about 2.5 per cent yield to maturity,it’s true that  the “theory” behind defensives is being tested in the minds of investors.

Yes, they will smooth out volatility of returns, but in this market they will pay you bugger-all. And bonds may one day lose you money.

At the Morningstar Investment Conference in Sydney on May 19 Ibbotson Associates head of multi-asset income Brad Bugg put it succinctly when he asked: “You’ve got to ask: are government bonds going to give you the diversifying qualities you would normally expect?”.

Changing times

It’s tempting to blur the line between defensive and growth assets but easy to get burnt.

Anyone who went deep into top 20 “yield stocks” a year so ago figuring the capital investment would simply drift  northwards learnt a lesson. Nonetheless, Australian retail investors still find their addiction to equities hard to shake off. 

At Morningstar’s 2015 adviser seminar, 90 per cent of the audience forecast that global equities, Australian equities or alternatives would be the best performers in the year ahead.

This year those "growth assets" came in placed fourth, fifth and sixth out of the sample of six.

Fixed income and cash were at the top.

If the RBA is tempted to lower the cash rate further, fixed income may place near the top again in 2017, although Schroder’s head of strategy multi asset, Simon Stevenson, is convinced government bonds are “very expensive” at the moment. “You’ve got to look outside your traditional diversifiers…such as fixed income,” says Stevenson, who currently favours cash and currencies as “useful diversifiers”.

Source: RBA

Strict definitions no longer apply

The idea, of course, is that diversification is good because then it’s harder to blame someone when one particular market crashes.

Markets never sleep, though, and plucking results from regular 12-monthly intervals is great for a discussion point but really means nothing. The characteristics of asset classes can change, to the point where it may be spurious to stick to strict definitions of what’s defensive and what’s growth. “The most relevant example in our portfolio recently is using emerging market debt as a growth asset,” says Ibbotson’s Bugg.

Bank deposits may pay almost nothing but it’s silly not to run a cash balance as a collection point for dividends or to fund opportunistic acquisitions.

Investors dedicated to fixed income may consider venturing into the realm of “unconstrained” active funds, where managers are set free to sift the deep reserves of corporate and sovereign debt around the globe, some of which is shiveringly low on the credit scale. It isn’t an easy field. Bentham’s Wholesale High Yield Fund returned 0.21 per cent in the 12 months to April 30. (And 9.19 per cent annualised for the past 10 years…it pays to be patient.) 

Long term ETFs 

Passive exposure to international credit is another option, with iShares and Vanguard creating a new ETF sector on the ASX with five launches between them late last year, all of them hedged for currency risk.

Key stats for the funds indicate it’s a space to watch but not leap into: all the securities in the iShares Global High Yield Bond Fund are rated BBB or below, and the portfolio has average duration of about 4.5 years. (The longer the duration, the more sensitive a portfolio is to interest rate changes. Unconstrained funds can engineer zero or negative durations.)

iShares Global High Yield ETF returns, YTD

At current rate settings yield to maturity for the iShares ETF is estimated at 6.09 per cent, and investors who are comfortable that rates around the world will stay this low for the next five or so years can wade on in there. Everyone else will stand on the sidelines counting the minutes until central banks raise rates and global credit becomes cheaper.

That’s the position we’ve been in for quite a long time now, including the 90 per cent of advisers at Morningstar’s conference a year ago who didn’t pick fixed income as the best performer for the year ahead.

“Even earlier this year people were thinking the…next move in interest rates was going to be up,” Bugg told the crowd at this year’s event. “But I think that view has changed dramatically.”

As you can see even the professional investors are deeply puzzled, don’t be too hard on yourself if you are finding it puzzling as well.