Is it time to go back to basics?

Despite the US Federal Reserve looking to hike cash rates in the next few months, the path to significantly higher rates is likely to be slow. Reflecting this, bond yields are still only marginally above their all-time lows and yields in other asset classes are not offering much either.

We expect 2015 to mark the fourth consecutive year of positive performance in equity markets. But in a low-growth environment, investors are wondering just how much longer this equity run can continue. In Australia the corporate landscape remains soft, with negative earnings growth from equities for the past three years, and it’s unlikely to turn positive until 2017.

So in this environment, what should investors be doing? In a way it’s back to basics. There are two known ‘knowns’ in investing – the equity risk premium (ERP) and portfolio returns benefit from diversification.

Equity risk premium

There is overwhelming data that tells us of a premium over cash and bonds from investing in equities. While over very long periods the excess return of shares over bonds has varied, since 1900 the realised ERP has averaged more than 4.5% for the US and close to 6.0% for Australia. We are mindful of starting point biases and it is our assessment that the appropriate equity risk premium going forward, for developed market equities, is somewhere between 3.5% and 4%. For Asian and emerging market shares it is slightly higher – between 4.5% and 5.0% – reflecting greater volatility.

Markets are also cyclical, so entry points matter. However, if we look at equity valuations today there are few signs of extreme stress. While the US market looks almost fully valued, other markets such as Europe, Japan and Asia continue to offer attractive value.

With cash rates and bond yields likely to remain low, and even with single digit equity market returns, investors will continue to be compensated for risk and equities should remain an asset class of choice.

However, looking forward we can’t ignore the fact that equity market risk has increased as the valuation buffer has reduced. Up until the GFC, Australian investors had for many years benefitted from the resilience and outperformance of Australian equities. However, Australian shares have underperformed global markets over the past five years and this is likely to continue with growth being subpar, the banks remaining under pressure to improve balance sheet strength and continuing headwinds from the commodity sector. Global economies are also sensitive to shocks that can turn anaemic growth negative and, even in an environment where credit growth improves and business and consumer spending contributes to stronger than expected economic growth, this is likely to give rise to inflation concerns in the current accommodative monetary environment.

Diversification

So let’s turn to our second ‘known’ – the power of diversification. Diversification is all about trying to diversify away from equity risk, which is typically the biggest risk in most portfolios. It seeks to identify and invest in assets/strategies that are uncorrelated to equity risk – specifically risks that are related to economic growth and its impact on company earnings.

The most obvious diversifier comes from investing in government bonds. In the event that economic growth falls, typically you see cash rates lowered, which reduces bond yields and increases capital value. The longer the maturity or duration of the bond, the more price-sensitive it is to changes in the bond yield. Despite the current low level of yields, bonds will outperform equities in the event of a significant correction, providing some offset to losses.

Currency is another important consideration given the Australian dollar’s propensity to underperform in falling equity markets, hence boosting returns from unhedged international equities.

Property and infrastructure – both listed and unlisted – have some correlation to economic growth but are also linked to supply/demand factors, inflation and cash rates, and so can perform differently to equities.

Private Equity is affected by economic cycles but is also influenced by the underlying manager’s capability in turning around and extracting value from businesses.

Accessing value-add or active management in the market is another important diversifier to equity markets. While we recognise that there are some markets where the ability to source excess return is difficult, such as in the US equity market, there are other markets like Australia where there is strong evidence of the ability to add value.

Finally, you can invest in a portfolio which takes active decisions with regard to asset class weights within the portfolio. This is called Dynamic Asset Allocation. This could mean moving the amount held in various asset classes within a narrow range, taking tilts to underlying countries/currencies/fixed interest markets/asset classes or more actively changing the allocation between asset classes to significantly change the risk profile of your portfolio, and therefore the factors that are likely to drive performance.

Portfolio construction to maximise returns

In the current environment, investors should be evaluating the level of diversification across investments/portfolios. Portfolio construction is a specialised skill that can maximise investors’ returns – even in challenging markets. This was witnessed in the latest September quarter when, despite sharp falls in equity markets, diversified funds only realised between one quarter and one third of the drawdown. There are a range of multi-asset vehicles available to investors that cater for differing risk appetites. In an environment where the ability to benefit from easy wins is behind us, and with the expectation that conditions will remain challenging, it makes sense to invest in a professionally managed solution.

Important note: While every care has been taken in the preparation of this article, AMP Capital Investors Limited (ABN 59 001 777 591, AFSL 232497) and AMP Capital Funds Management Limited (ABN 15 159 557 721, AFSL 426455) makes no representations or warranties as to the accuracy or completeness of any statement in it including, without limitation, any forecasts. Past performance is not a reliable indicator of future performance. This article has been prepared for the purpose of providing general information, without taking account of any particular investor’s objectives, financial situation or needs. An investor should, before making any investment decisions, consider the appropriateness of the information in this article, and seek professional advice, having regard to the investor’s objectives, financial situation and needs. This article is solely for the use of the party to whom it is provided.