Just about the only option for investors looking at their fixed income allocations at the moment is to replace beta with alpha for at least a part of their portfolio. There is not a lot else jumping off the page, according to Philip Moffitt, the head of fixed interest for Asia Pacific and partner at Goldman Sachs Asset Management in Australia.
“Normally, in this sort of environment with record low rates destined to go higher in the US and perhaps elsewhere, you’d expect one or two other options to be available. We had corporate credit a couple of years ago, or you could have had more emerging market debt or opened up mandates to allow them to become more diversified,” he says.
“Now, everyone’s struggling with exactly the same issues… The only choice, really, is to replace beta with alpha and that’s a leap [for super fund trustees]. If you reduce your beta risk in favour of alpha you are relying more on manager skill and that is a different balance for most plan sponsors.”
Investors know that they are looking at potential capital losses when interest rates start to rise again, which is generally assumed will happen first in the US. In the absence of other options, they have tended to trade off portfolio quality or liquidity to try to add extra return to counteract this risk.
Moffitt, who has been a senior fixed income and currency manager at GSAM in Australia and globally for more than 15 years, and before that at Bankers Trust, says that people, including professional advisors, need to make the adjustment to what is being referred to as the “new normal”. This is where returns for both equities and bonds, the two main asset classes, are likely to be a lot lower than they have been for the past 50 or so years.
“Retiree financial plans are still being written on the assumption of six or seven or even 8 per cent annual returns,” he says. “That’s just too high. They are using historical returns to predict future returns and in the planning for people’s retirement.”
The long-term neutral market return of the risk-free asset class – cash – with an added premium for risk will be lower than it has been in recent memory. There is less inflation risk, almost anywhere in the world, and slowing natural growth rates almost everywhere, especially in the developed world.
Moffitt adds that the discussion of alpha replacing beta is also taking place in every other asset class at the moment. It’s just that it seems more pertinent in fixed income.
Any market disruptions will present opportunity for patient investors. Regulatory changes and relatively expensive funding for leverage has meant the big banks, in particular, become less efficient risk transfer agents. Finding buyers and sellers to offset each other is less efficient than warehousing risk as an intermediate step.
“The Street will get better at this,” Moffitt says, “but the connection between buyers and sellers is not as strong if there may not be enough investment bank balance sheets to be broker. Investors will eventually be able to sell, if they want, and this will eventually be helped by new technology, matching buyers with sellers. In the interim, investors like us or our sovereign wealth and pension fund clients will play a bigger role in liquidity provision.”
The expected big sell-off in fixed interest hasn’t happened yet. Most institutional investors have maintained much of their defensive portfolio allocations which they built up around the time of the global financial crisis.
As an observation, Moffitt says it appears that the volatility due to situations such as the Greek crisis or the China sharemarket meltdown has been much lower than you would expect. This suggests that the normal “risk takers” in the market do not have as much “risk on” as they could because they are worried about the direction of markets.
When the outflow from fixed interest happens, it is likely to be fragmented, Moffitt believes. “They will be moving away from fixed income but not necessarily increasing risk across the portfolio,” he says. “Some of it will go to cash and cash-like products and others will take up more corporate debt and move into emerging market debt or have more equity… There is no question that money is already going into liquid alternatives too.”
Fixed income managers are, arguably, able to exploit more micro-market inefficiencies than managers in the so-called growth asset classes. The problem, Moffitt says, is those inefficiencies are not that big. You can generate a reliable return but you have to introduce leverage to make it significant. And leverage has become more expensive.
“The ultimate solution for local super funds is to trust their manager with greater flexibility. It’s becoming more of a ‘trust’ conversation with our clients,” Moffitt says. “You need to be in the market to access all the skill which is available to you.”
– Greg Bright
GSAM’s compelling case for active fixed income