Before investing in assets for alpha, advisers must first have an appreciation of the risks that threaten returns on their investments.
This is the view of Charles Hepworth, investment director of GAM Model Portfolio Service, one of the speakers at the joint FTAdviser GAM roadshow in Guildford this month on redefining safe havens in an increasingly uncertain investment environment.
Two key drivers of financial markets this year are uncertainty in oil prices and increased political risk stemming from the onset of so-called populist movements across Europe.
While the market continues to obsess over most European election results, Mr Hepworth said the march of anti-establishment politics had been halted in Holland following its own general elections this month.
This should go some way to allay fears about the outcomes of future polls taking place throughout the continent – not least in France where the emergence of the National Front has been much commented on, he said.
Brexit
When it comes to the UK leaving the European Union, consumers may have to scale back their spending in the year to come, according to Mr Hepworth.
Two other notable market drivers to watch out for are the state of the Chinese economy and global reflation.
On the subject of China, he said the nation had dodged a bullet when stimulus measures announced last year were misdirected and as a consequence had failed to offer the same sort of benefit gained years earlier in the post-credit crunch years.
With regards to global reflation, Mr Hepworth said stimulating economic growth through reflation has typically been done by central banks via interest rates cuts and quantitative easing, but both have reached a point where its continuation is not having a telling impact.
He said reflation was going to be “a longer burn,” adding that the current approach adopted by central banks indicates that markets are agreeing more with the US Federal Reserve on the direction of interest rates. This is because US inflation has picked up – driven by the improving health of the employment sector. Average hourly earnings are going up, which justifies upwards movement on rate rises, Mr Hepworth said.
However, the more pertinent threat to all market directions is the advent of Donald Trump to the post of US presidency, according to Mr Hepworth, who described the businessman as the epitome of market uncertainty.
He said: “There is nothing too cataclysmic until we get on to the Dark Lord [Donald Trump] himself. His Tweets are aggressive against anyone who says anything against him. He is quite a dangerous character.
“If we look at his policies, we don’t honestly know what he is going to come out with. The border adjustment tax is one example of where he is being led behind the scenes. We don’t really know where he stands on it.”
“We don’t know what he is going to do. I don’t think he honestly knows what he is going to do.” Mr Hepworth reassured industry delegates that he would not be surprised if some of his policies fell by the wayside.
In terms of next steps for advisers and their clients, Mr Hepworth said: “Continue to engage in equities – there is no alternative for longer-term investing."
One of the challenges facing advisers in the current low return investment environment is achieving a risk/reward balance.
Graham Bentley, managing director of GBI2, said intermediaries may be advising clients to take too little risk. He said: “Risk is meaningless without a consequence.”
“It is about objectives and what people want. They [clients] have to be guided to understand how likely they are to get to where they want to go with the current set up of their portfolio.
Risk
“The rule to working out risk is 'probability times impact': what is the likelihood of the bad thing happening and what is the impact on me if it does. This applies not just for investments but for life, for love – for everything.”
Investment professionals mistakenly use risk and uncertainty interchangeably, when risk is measurable, uncertainty is unmeasurable risk, Mr Bentley said.
Fears of the state of the global economy have historically driven investors to pump their money into gold – under the illusion that it is the ultimate safe haven. Mr Bentley rejected this sentiment.
He said: “It is not an investment. It doesn’t produce income. It is a bet that everyone else will go into gold if they get scared. Allowing for inflation, it is worth less than it was in the 1700s.”
When it comes to investing over the long term, Mr Bentley adopted an analogy coined by veteran investor Warren Buffet of: "Someone’s sitting in the shade today, because someone planted a tree a long time ago.”
He warned alpha-seeking investors to beware of closet trackers within the Investment Association All Companies sector.
He estimated that 60 per cent of the fund in this investment universe falls under the closet tracker banner and called for the publication of the active share versus tracking error on fund factsheets to be mandated.
The lead question that directed conversation in the panel sessions, involving the keynote speakers is what will generate alpha in 2017.
Absolute return funds, designed to generate positive performance regardless of market conditions have generated some derisory investment performance in recent history.
Absolute return
In numerical terms, to the IA Target Absolute Return (AR) sector has returned 2.77 per cent over a two-year period to 17 March 2017, according to FE Analytics data. It should be noted that the sector generated negative performance for almost five months to early July 2016.
Responding to a question on the suitability of absolute return solutions looking ahead, Mr Hepworth said: “AR managers had a really tough time in 2016. We had minor positive returns but it wasn’t a lot to shout about and certainly after their fees are taken into account, you've got to question if they are meaningful in portfolios.
“They probably got too complicated and maybe even too diffused. They are not what they used to be and we think we can get better returns from less complicated and cheaper products.”
Kier Boley, head of fund research at GAM, said many AR strategies have historically generated impressive returns through investment mechanisms that benefited from high interest rates. Such funds have suffered a reversal in fortunes in the low interest rate environment.
Mr Bentley alluded to the fact that the IA Targeted Absolute Return sector was the best retail seller of 2016, pulling in £5.1bn, adding: “What is it that is making people buy this stuff if not for the fact that it is a dramatic performer?
“One of the reasons is there seems to be a degree of desperation to find some sort of a bond proxy in the portfolio that would be protected now that we are moving into this phase of increasing interest rates.
“The problem is there is no decent benchmark in which to interpret what sort of returns you are going to get from a particular set of [AR] strategies. Therefore, no asset allocator worth their salt is going to try and work in AR strategies just to satisfy demand.”
Underperformance
Whereas, after five years of underperformance because of a weakening of emerging market currencies against the US dollar, emerging market fixed income has gone through a host of readjustments.
This has generated attractive value and fundamentals, according to Mr Boley.
On convertible bonds, he added: “They have been the poor cousin to high yield bonds because of the way companies have been rewarded for issuing plain vanilla high yield bonds. But we start to think that this year there will be a turning point.”
For Jeremy Smouha, chief executive officer of Atlanticomnum, investment in bonds in the financial services sector is a potential solution for investors seeking to generate impressive returns through the debt market.
He said: “Financial companies are getting safer but people are still worried about what happened during the financial crisis that they have not realised the huge reduction in risk in banks.”
In his earlier keynote presentation, Mr Smoutha said banks are stronger for the tightening in financial regulation which followed the 2007/8 financial crash.
For example, banks now boast bumper cash reserves due to solvency requirements, he said.
His top holding is Lloyds, which trades very high and gets close to 6 per cent, then Old Mutual, which gives close to 5 per cent, followed by HSBC, Hiscox, Legal & General, Prudential, British Insurance and Bank of Ireland.
Although banks may struggle, it would likely result from profitability issues rather than a solvency one.
An industry delegate posed a question on the suitability of bond exchange traded fund investments to the panel. One of the main draws of bond ETFs centres on the fact that they trade throughout the day and are therefore more liquid than a mutual fund.
Mr Boley said: “The key question is what the underlying assets the ETF is built on?
“[A bond ETF investment] looks fine when the market is a buyer’s market because liquidity is very good. But at the same time, because the regulatory environment has forced investment banks to not use their own proprietary capital for market making, you find that the markets do not have another side to the trade – to warehouse liquidity.
“When certain ETFs suffer redemption, suddenly the price of the ETF becomes very volatile on the downside.”
Myron Jobson is a features writer of Financial Adviser
Key points
There is plenty of political uncertainty around threatening investments.
It is important to consider the objectives of taking risks.
Absolute returns have generated poor returns recently.
