The cautious investor’s dilemma

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Jonathan Shapiro

John Coombe, one of the veterans of influential asset consultant JANA, was recently given an ominous greeting from an American peer in the asset allocation community.

“Welcome to our world and good luck,” was the message. “You will look like an idiot if you own a defensive asset, and worry about the downside risk.”

JANA’s John Coombe says super funds have promised to meet a target above the inflation rate. AFR

While there has been no shortage of investment risks, foreseen or not, conservatism has generally been costly in a world of steadily declining interest rates.

Even a one-in-a-hundred year pandemic only momentarily justified a cautious approach as risk assets have ridden the tide of cheap money.

But the enduring challenge facing those like Coombe, who is advising Australia’s largest super funds, is that we are now very much part of the negative real rate complex, where bonds pay less than the inflation rate.

“Here I am sitting with a bond portfolio that I know isn’t going to actually beat inflation,” says Coombe, who points out JANA’s super clients have promised to deliver a return above inflation. That means the rest of the portfolio has to perform heroically to compensate.

There’s no easy answer to counter this, says Coombe, who spoke to The Australian Financial Review ahead of the firm’s annual conference which will be held virtually this week.

Super funds are being forced to work harder to find assets that can deliver solid returns relative to the risk. These include more esoteric asset classes that generate income, such as pre-paying legal fees, or picking up the corporate lending slack from the banks.

“There will be sufficient assets but they do come with more risk.”

Defensive debate

In fact, the very definition of a defensive asset is being questioned, not just by the prudential regulator but by a dramatic change in circumstances.

Airports, toll-roads and property assets that would be expected to deliver resilient cash flows that keep pace with inflation, even in downturns, have been hit hard by government shutdown orders.

Coombe’s challenge, and that of all Australians previously reliant upon property, bank stocks and deposits, is having to take more risk to maintain the same income.

“The reality is whatever income stream you were earning out of that term deposit it has halved in the last three months,” he says. “The other way of looking at it, is the amount of assets to get the same income stream has doubled.”

In most cases that means allocating to stocks that deliver income via dividends.

JANA however has been slightly cautious on equity markets and in particular Australian shares, because of the exposure to China and the challenge facing the banks in recessionary conditions.

While its concerns about a slowing Chinese economy did not eventuate, the banks have battled. Given the run in US stocks, JANA advised clients to remove the underweight allocation to Australian stocks, which look better value.

Liquid confusion

Coombe says Australia’s super funds have coped well in this unusual environment. Their liquidity proved “robust” despite allocations to illiquid assets such as property and infrastructure.

The introduction of the early withdrawal scheme did however create some challenges. Coombe estimated the costs to returns of meeting these redemptions was around 0.3 to 0.4 per cent.

“That was the cost of providing liquidity to people that were in desperate need,” he says.

While the valuation applied to illiquid assets sparked intense debate at the height of the crisis, Coombe is more bewildered about how public equity markets can rapidly change valuations.

“We know from studies that the average yield in the stock market is somewhere around 4.5 per cent in Australia and around 3 per cent in America. Yet the valuation can change from 22 times to 10 times.

“That is more amusing than the premium I get from holding a illiquid asset where the valuations don’t change much.”

In terms of manager selection, what stands out for Coombe is how value investing, which has lagged for the best part of ten years, has fallen further behind.

“The acceleration of the underperformance has been extraordinary in the last nine months. They [value managers] went into COVID with a portfolio that you did not want in a global shutdown: overweight cyclical companies.”

Equity investors with a growth or quality bias fared better. While Coombe says he expects an eventual rotation into value stocks, he’s apprehensive that it will be sustainable.

“Every recovery is different but there has been a secular change to a digital economy and I don’t see that changing.”

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