It may not have felt like it at the time, but the past nine years have been a golden era for investors.
Bond and equity markets have risen steadily and people have been handsomely rewarded for taking risk. The problem is that people can be seduced into assuming that the future will be like the past.
This is not just an assumption made by novice investors; it is endemic in the way portfolios are constructed. In a world where the future looks exactly the same as the past, it is possible to simply set an asset allocation and, with only occasional rebalancing, ignore it for twenty or thirty years – the average duration of a pension accumulation strategy.
There are good reasons why the environment of the next decade will not look like that of the past decade. Fundamental to this is the shift in monetary policy from one of low interest-rates to one of higher rates. Monetary policies deployed since the financial crisis has been an experiment and its influence on financial markets unusual.
It is a view commonly-held that investors only need to pick a few assets based on their historic risk and correlation qualities, put them together and they will be ‘safe’ – i.e. adequately diversified. Admittedly, this has been a very effective strategy to date as equity and bond markets have risen in unison. But there are compelling reasons why investors need to be more considered in their future approach.
Lock and leave?
Take fixed income. This is no longer an asset class you can ‘lock and leave’ for the long term. This can be seen in the changing make-up of fixed income indices, which are becoming increasingly sensitive to interest-rate movements. Duration of fixed income indices has become longer as governments and companies have sought to lock in cheap financing costs by issuing longer-term debt.
Spain launched a 50-year bond in 2016, joining France and Belgium. Switzerland has a 42-year bond, while Italy has also sold similar maturity debt. Corporates have been doing the same, particularly those who saw increasing volatility in the bond market ahead of time. This issuance has been matched by demand. Investors have sought longer-dated debt as a means to combat the low income available on short-term bonds. This is all reflected in the make-up of indices, which have been shifting over time.
If an investor has ‘unthinking’ allocation to corporate bonds and/or government bonds, they now have a problem. Just as interest-rate risk in fixed income is moving higher, compensation for that risk is declining. In corporate bonds, spreads over government bonds are at historic lows, which means the ‘credit’ part is not providing much compensation either.
There is another important question in this environment: what if the investment doesn’t keep pace with inflation? If an investor aims to minimise interest-rate exposure, they risk not generating sufficient income to keep their portfolio stable in terms of purchasing power.
There is an argument that this is all simply the swings and roundabouts of investment. Yes, certain asset classes won’t perform at certain times. That is why investors hold a balanced portfolio. We would argue that this is an inadequate response. The ‘easing’ environment lasted almost a decade; it is plausible that the new environment could also endure for many years. Investors cannot afford to be in the ‘wrong’ asset class for a significant chunk of their accumulation phase.
To our mind, this is not a reason to avoid fixed income. It has a role as a diversifier, income generator and, in certain cases, to provide capital growth. However, it should suggest a more ‘thoughtful’ active approach. There are still opportunities in fixed income, but they are idiosyncratic. They are often not to be found among the largest and most liquid areas, where other buyers are chasing the same opportunities, but in smaller, more niche areas of the market.
Investors have had it relatively easy in recent years and haven’t had to be particularly discriminating about where they invest. This is changing as the environment changes, particularly as the UK faces potential interest-rate hikes in the coming months.
With something as important as a pension pot ‘buy and hold’ is an inadequate response. A more active and considered approach is vital to preserve wealth over time.
James Johnsen is Head of Business Development at Church House Investment Management