The Hunger for Yield
This is a summary of a session from the Money Management Institute’s 2013 Spring Convention. The panel was made up of three experts all from large, institutional asset management firms:
- Daniel Loewy, Co-Chief Investment Officer, AllianceBernstein
- Donald Plotsky, Head of Product Group, Western Asset Management
- Robert McConnaughey, Head of Equity, Columbia Management
The session moderator was Kevin Keefe, Executive VP, Advisor Group.
Can you discuss some of your methodologies around asset allocation and portfolio construction?
According to Plotsky, a lot of clients are worried that fixed income is no longer a viable investment. He and his firm reject that notion and believe that investors need to re-think their approach to asset allocation. Income is a critical component of any long-term investment program, he stressed.
Loewy believes that there are three keys to successful asset allocation:
- pro-active – long-term assumptions about strategic asset allocation doesn’t cut it anymore, must have a pro-active approach to keep clients in the game to capture long-term risk premium
- flexibility – traditionally, risk was managed from the bottom-up using individual portfolio sub-components, investors want to manage absolute risk, not relative risk, requires a more flexible approach to be able to take advantage of opportunities
- customization – there is no one-size fits all portfolio, need to focus on individual outcomes such as growth, income, real return or capital preservation
Most investment objectives say “maximize total return relative to the benchmark,” Plotsky observed. But this becomes irrelevant to the end investor when the benchmark return is negative. Generating a reasonable amount of growth over time and re-investing the income coming into the portfolio should be your objective, he said.
The traditional notion of asset allocation, with a 60% equity allocation, should be rejected, Plotsky proposed. Investing that much of your portfolio in equities is like walking into Las Vegas and putting all of your money on black, he said.
This model is challenged because equities haven’t provided the gains, in the current low interest rate environment, traditional fixed income is unlikely to provide the income required, alternatives haven’t provided the expected equity-like returns with fixed income-like volatility.
What is Risk On/Risk off?
According to Loewy, Risk on/Risk off is a market environment when assets are moving in unison based on a common macro-factor or concern. Over the last several years there has been a dichotomy between deflationary forces brought on by the big financial de-leveraging vs inflationary forces generated by the tremendous stimulus from the world’s central banks, he said. This caused markets to quickly shift between assets as they attempted to adjust to investor sentiment.
Markets in this context oscillate between despair and euphoria, which makes it difficult to manage assets, Loewry noted. Investors are most vulnerable since they want to get out of markets during Risk Off periods and then want to get back in when it’s Risk On, he said.
Risk-On/Risk-Off provides counter-cyclical opportunities for asset managers, Plotsky cautioned. After the US rating downgrade in 2011, investors panicked and blew out the spreads on credit/debt instruments with high yield bonds yielding 10% or more. This required sticking to fundamentals in order to avoid getting burned, he noted.
According to Plotsky, the US downgrade didn’t impact well-run global companies with good balance sheets. It turned into an opportunity for them to increase their market exposure by avoiding running with the herd. Maintaining a strong fundamental basis allows investors to add to their positions when the market gets scared, he pointed out.
How do you think about strategic vs dynamic asset allocation?
A successful strategic asset allocation requires a long-term framework and dynamics, McConnaughey stressed. It’s important to continually evaluate change and determine what is the new normal, he said.
Certain asset classes evolve over time, McConnaughey continued, which means that prior lack of correlation doesn’t imply future diversification. For example, REITs were once viewed as a discrete asset class, mainly because they were a very small player. But now that they represent 10% of most major indices their correlation has increased to the point where they cannot be used for diversification from equities, he explained.
Plotsky agreed that focusing on historical relationships can cause you to miss temporary shifts in correlation. Income tends to be persistent over long periods of time, he observed, so the answer is not to avoid assets that are historically highly correlated with equities, but to avoid equities when there are better opportunities elsewhere.
What are the biggest investor misconceptions about seeking yield?
Investors should remember that yield is not the same thing as return, Loewy said. The reason that many high yield investments are correlated with equities is that they will be similarly affected if markets go down. The world expects lower growth and lower risk in the near future, so any acceleration to upside will cause yield strategies to underperform, he warned.
What’s wrong with equities?
There is a big problem with equities, because the markets have been broken by government, Plotsky exclaimed. For example, Apple has $150 billion on their balance sheet from overseas sales because US tax policy discourages repatriation. These policies change the historic agreement between shareholders and companies. However, it doesn’t affect REITs and utilities, he pointed out.
is there a bond bubble?
It’s possible to substitute the word ‘Treasury’ for ‘bond’ in that question since the Fed has said they will keep interest rates low for as long as possible, Plotsky proposed. Treasuries offer no value. Outside of traditional fixed income securities there are many opportunities including middle market debt and structured products, which could deliver inflation+ returns, he noted.
Loewy didn’t agree that there was a bubble, but did propose that bonds are currently over-valued. Treasury yields are about 1% below where they should be, he continued, but don’t expect a sudden rise in rates. With low yields come low equity volatility, which provides an opportunity to invest in options, since the carry costs are low, he offered.
This is a “bizzaro goldilocks world”, McConnaughey proposed, which means that things need to be bad in order to get central bank support, but not so bad that it becomes catastrophic and everything collapses. While there’s a low probability of collapse, it’s still a fragile world, and asymmetrically negative, he stated.
There are yield arbitrage opportunities where there is perceived stress, McConnaughey said. He explained that a very profitable global company that is headquartered in a troubled European country like Italy, could be beaten down by frightened investors and would be a value opportunity for them.