Why investors must be braver for longer

In our exclusive interview with Alva Devoy, Managing Director of Fidelity International Australia, we explore the return of volatility to global markets in 2018 and where that leaves investors positioned into 2019 and beyond.

Devoy talks of the “level of insanity” in politics that is impacting markets at present, Fidelity’s adjustment in asset allocations, including its focus on emerging markets and the launch of its first Australian listed ETF, and why active management in the current volatile conditions is essential.

She says investors need to be braver for longer, pointing out that now is not the time to be taking your money off the table but instead staying invested in a very risk-adjusted way.

Listen the podcast below or read the full interview transcript.

Tony Kaye: Hello, I’m Tony Kaye the editor of InvestSMART and I’m talking today with Alva Devoy, who is the managing director of Fidelity International in Australia. How are you, Alva?

Alva Devoy: I’m pretty good! Beautiful sunny morning in Melbourne.

Tony Kaye: It is nice, it is nice. Now I wanted to talk to you today really about your views on the markets now because we’re in quite interesting times. I wanted to start by going back to a report that you did right at the start of the year pretty much, which was talking about “An uncomfortable balance”. Perhaps, lets revisit that report, because you have some interesting views in there and just take it up to where we are now, once we’ve had the opportunity to see how things have panned out over this year.

Alva Devoy: In terms of the start of the year, why I talked in a report around “uncomfortable balance” was, we’ve had a fantastic bull run in all assets concurrently. But, pretty much everything has gone up all at the same time. We were coming into the end of 2017 into 2018 and questions that are still being asked today were being asked then, around “Is this the end of the bull run in assets or some assets?” “Is there anything left in terms of returns on the table?” I know if I’m an investor, that I’ve had a honeymoon period where I’ve made quite a lot of money if I’ve been invested throughout that period since 2008 and the risks are now rising that we’re either topping out, but also I don’t have any downside protection in the price anymore.

We know that assets have run hot. So, the questions were being asked around the potential for this business cycle to end, and therefore asset prices to roll over. And we look at the year that we’ve had, we knew volatility was going to come back and that was absolutely a given at the beginning of the year, because that was one of the I guess incongruent missing parts of markets, was this wholesale everybody pointing the same direction and everything making money. Meanwhile, risks and transition periods were merging in the system and we knew we were moving into a tightening environment in the US.

So, I look at the year that we’ve just had, in terms of asset behaviour and also the backdrop. And I do want to point out what we have achieved in economies. We have moved from the heroine of choice, which was quantitative easing, easy money, low rates, zero rates in some areas. We’ve already transitioned into a tightening environment., quantitative tightening, money draining from the system everywhere and rates going up in the US. And we made money initially in the year and then volatility arrived, and we have seen the US in particular, purely because it’s not … US equities, purely because they haven’t gone down as much as other assets, they’ve actually, despite a raising rate tightening environment, re-rated relative to every other asset.

That’s really interesting to me, that we’re at this junction now as we’re looking into 2019.

Tony Kaye: We knew a lot of these things were coming though, didn’t we? We knew that rates were going to rise in the US. We knew that QE was going to be taken away. So those were the known things, then there were the unknown things which have cropped up this year, such as the trade war, etc. So, that’s created this whole climate of volatility now. How are you approaching that as an asset manager?

Alva Devoy: So, I sit and look at markets, I’ve kind of sat back now coming into the end of the year, and I am very, very surprised at the level of insanity that is around at the moment, specifically at government level and in political arenas all over the world. But, that insanity when you identify it and look at how it’s actually, how it’s pricing risk assets, means that there’s opportunities becoming very, very live in certain markets. But as an investor looking into next year, the questions now are, it’s almost like the end of the business cycle question is kind of moot. We’ve had this shift in business cycle, and now the question is more, “how do I take advantage of this insanity, mispricing in assets, and also cushion against volatility and downside risk?”

So if we take the trade war, which you’ve mentioned, I sit back and think as Australian investors, we know an awful lot more about China than a lot of our counterparts elsewhere. We have been engaging with them on an economic sense for decades. We have benefited from their ability to manage their economy to the point that they want. Taken, case and point, everything basically falls off a cliff in 2008.

China had been dependent on the US economy as an exporter of goods to the US economy, and decides, right, we have to stimulate our economy to maintain our social obligations, which in China is full employment. They enact a $US496 billion stimulus package, were going to build roads, build houses, etc. and Australia benefits from that.

And we sit here a decade later looking at an economy that has completely shifted, but no less dependent on its own designs and bullets in a gun if you like to achieve what they need to achieve. So, I look at the trade war and I look at how assets in the regions have been absolutely hammered. Emerging markets in particular, emerging market equities, including China and emerging market debt.

What you have is an economy that has already shifted labour intensive manufacturing to other economies. They’ve already moved up the value chain in terms of what they produce for export on an inter-regional basis and to the US and beyond. And that’s going to pick up a head of steam, because China will circumnavigate trade tariffs by having some production in China but finishing in Vietnam, Taiwan, Korea. So, trade is not going to stop. They are going to adjust to 50 per cent of their goods now having tariffs for the US, to utilise a structure that’s already in place for them, their partnership and sometimes their called ‘puppet economies’ as well in the region.

So, I think if you stand back and think everything’s going to hell in a hand basket for China, there’s trade wars, there’s a slowing economy on the ground, you’re missing the point. You’re missing their level of control to shape shift, absorb this disruption in a way other economies absolutely can’t, and that presents opportunities.

Tony Kaye: So, have you had to make some serious adjustments in your risk allocations during this period over 2018?

Alva Devoy: Yep. So, if we were looking at our multi-asset allocations to various regions, we had stayed long US and Europe at the beginning of the year; we had increased our cash levels for a period of time; we dialed down risk, very far at the risk curve. We’d also reduced duration risk as well, because US rates are going up. And, more importantly, we have been looking for ... across, if I was looking at multi-asset structures within Fidelity, you’re looking for decorrelated assets, things that just will not move together. So, those will levers have protected us on the downside and now we’re at a different juncture. If we’ve got cash on the sidelines, where are we going to deploy it? Where are the opportunities?

And, for us, when you’re looking at a region like emerging market equities, which has already worn 22 per cent-23 per cent downside, emerging market debt has underperformed all other debt as well because of Turkey in particular and Argentina, how much risk is priced into those assets and therefore do they represent an opportunity today? And very carefully we will start to deploy cash into those regions from here.

Tony Kaye: Now, I wanted to get to the new active ETF product that you’ve launched in the last few weeks. That’s actually based around emerging markets?

Alva Devoy: It is. Yep.

Tony Kaye: So, what made you come to the market, at this time, with an emerging markets ETF?

Alva Devoy: Yeah, right in the middle of huge volatility. There’s a couple of different reasons. I’d like to take a step back and talk about active ETFs for a couple of minutes, because a little bit like superannuation in Australia, we just take it for granted, and we actually take a superb system which builds for the future and better futures for all Australians going forward. And we kind of forget how beautiful and elegant a solution that has been to long-term financial wellbeing. So, we’ve had an asset base for pensioners here, for the pension industry in Australia to grow to $2.7 trillion. And we’ve had a cohort of that in self-managed super, now roughly $760 billion.

Then, we look at the ATO data that came out recently. We know that there’s concentration risk across all investment cohorts in Australia, from institutional pension funds, superannuation funds through to the SMSF, to Australian assets. But it is particularly concentrated in SMSFs, and so the latest ATO data was 40 per cent allocation to Australian assets.

And then you think about the environment that we’re living in right now with house price volatility and rolling off. Also, our banks in terms of their growth slowing, so the index doing it tough if I’m to look at the ASX. And so, how did active ETFs come about? It came out of a realisation from ASIC with the ASX, with APRA, etc, that diversification needed to happen, especially for this cohort of investors and savers. And how do we promote diversification? How do we make it easy for these investors, who like direct “Aus” equity investments and/or “Aus” equity funds, but also their property, investment properties, etc.

So, the active ETF vehicle was born out of ... well let’s make it easier for these investors who have a broker account to buy and sell units in funds that are funds based on assets everywhere in the world. A so a very neat mechanism was designed and built so that as an active asset manager, a company like Fidelity can list our portfolios on exchange, and exactly like an individual would ring their broker and buy a bank share, sell a bank share, you can now buy units in an active ETF.

So we see the market begin to grow. Magellan was first out of the gates, they were part of the innovation process here in Australia. And we come to Fidelity and our ability to launch our funds on exchange. We look at the diversification need, and then we look at what clients were asking for us during this year. And in response to that, decision made not to launch Australian equities but to launch global emerging equities as our first fund, and then global equities will be our second fund. So, you can see us responding to the diversification need.

The global emerging markets decision was in part based around; it is a very high potential area for investment in terms of returns, because of the demographics in the region. But it is not without its risks. So therefore, if you are going to invest in global emerging markets, you need to be investing in an active way or via an active manager. So taking out beta exposure by buying a passive ETF to global emerging markets. The volatility we’ve just seen means that if I lose a dollar of capital today, and especially for older investors or retirees, my ability to make that dollar back is curtailed.

So you need active investment, protecting to the downside in global emerging markets, hunting out the really, really great opportunities on the other side, and packaging those in such a way an investor gets that diversification benefit, but mitigates downside risk. So, we thought it was one of the better strategies to launch through an active ETF vehicle.

Tony Kaye: Could you tell me a little bit more about what’s in that fund?

Alva Devoy: Sure. So Alex Duffy is the portfolio manager for this fund. He lives and works in Singapore. He moved into the region to be closer to the companies that he’s investing in. He has access to 48 dedicated analysts for the emerging markets region. He also works with a group of approximately 10 portfolio managers who have expertise in the region. They’ve been managing Asian equities, China equities, etc. So he brings that engine of research and investment capability to bear, to design and build quite a concentrated portfolio of stocks, 35-40 stocks, investing across the region.

His major concern is not losing a dollar of capital on behalf of clients. So, his first approach when he’s filtering his companies is to ensure that their structure, their management compensation practices, etc, are aligned with the end investor. So he doesn’t like investing in state-owned enterprises let’s say, because they’re designed for completely different stakeholder. So, he brings that lens and then he looks at the balance sheet structure of these companies to mitigate risk. Because, in emerging markets if you have companies borrowing in US dollars for investment in ... let’s say Indonesia, India, etc, you’ve immediately got a currency mismatch on your debt. And we’ve just had a period of rising rates in the US, rising US dollar, that would have taken a lot of companies who have that mismatch out of the game. So, he deselects those.

After you get through that, it’s into “right, I’ve got an opportunity set. What do I want to invest in?” So he is looking for technology companies, but also more importantly today, companies in other sectors that are using technology to become better at what they do and drive better returns. So, yes, he has some of the familiar names like Tencent etc, Alibaba in his fund, all the way through to an autos company, Neon being one of those from memory, in though consumer companies like Midea, which is a consumer goods company, washing machines for the normal household. But, very importantly, they’re a consumer goods company that are investing in R&D, and even through this cyclical downturn that we’ve seen in China, have not cut their R&D spend. Because they believe they can supply R&D and products to the likes of AEG etc, elsewhere.

So, it’s those sort of companies that he’s looking for. It’s almost like having two to three legs to an investment thesis. I’m looking for a demographic structural support, so we know consumerism is growing and the ability to spend is growing. We know technology is a great enabler. Can I actually get some of those levers in one company? And, that to me is … or to Alex … is, it’s a great long-term investment, but it also means that my insulation against the cyclicality of returns is better.

Tony Kaye: Now, I just wanted to end, going back to that report that we started with, your last point on that was, “Braver for longer”. You were basically saying that investors need to be braver for longer. Is that still your view?

Alva Devoy: I think you need to be more brave today, because the period of volatility that we’ve seen post a very, very calm long-term period in assets, will have shaken investors’ confidence. But this is the point of which you need to be more brave, this is the point of which true opportunities that will deliver returns over a three to five-year view, are now going to surfaced. Now is not the time to be taking your money off the table. Now is the time to stay invested and if you have cash to deploy, deploy it in a very risk-adjusted way. Now is the time for active management, and we are a believer as a house in passive plus active. It’s not an either or debate for clients anymore. It is a great ecosystem where, when passive is appropriate for low cost and just achieving exposure to a market, that is a great tool for investors.

Today, evermore prescient is the need for active investment. So, you need to seek out those active managers, not only that can find and generate high returning portfolios, but very importantly for the next year at minimum, those who can protect you against volatility, that can protect against downside risk. So, if you take the path of seeking an active manager, your first question should be “what’s your downside risk protection like relative to your benchmark?” I want to know that you are going to protect me from volatility as we move forward, and then I can remain comfortable through these periods of volatility to stay invested.

Tony Kaye: Alva Devoy, thanks very much for you time today.

Alva Devoy: Most welcome. Okay.