When the correlation between bonds and equities turns positive, there is only one way to shield an investment portfolio from severe losses, the Australian Retirement Trust’s Andrew Fisher says
Nobel laureate Harry Markowitz has been credited with the phrase that the only free lunch in investing is diversification.
But when Markowitz was forming his Modern Portfolio Theory in the 1950s, diversification meant dividing your money simply between bonds and equities.
In fact, for many years Markowitz split his own investment portfolio 50/50 between these two asset classes and only moved to a higher equity allocation later in life when he felt that he was “many standard deviations away from not being able to eat”.
As it turns out, the correlation between bonds and equities can turn positive at times, as investors experienced in 2022, and this meant diversification between these two asset classes no longer provided any risk benefits to the portfolio.
Therefore, investors today add in a third dimension in their approach to diversification: private assets.
Andrew Fisher, Head of Investment Strategy at the Australian Retirement Trust (ART), explained in a recent presentation to financial advisers how private assets saved the fund from plunging deep into the red last year.
We have defensive assets in our portfolios and their role is to diversify, but in 2022 that was not what happened. In fact, quite the opposite
“We have defensive assets in our portfolios and their role is to diversify, but in 2022 that was not what happened. In fact, quite the opposite,” Fisher said.
“What we found was that equities and bonds moved very much in line with each other and that is where we end up with a scenario where you have essentially negative returns across the page.”
The key driver behind the inversion of the bond/equity correlation was a rise in interest rates. This environment caused most assets to plummet in value.
“For 25 to 30 years interest rates went in one direction. There was a little bit of volatility over that period, but basically from 1987 to 2021 interest rates were falling and when interest rates fall it is fantastic news for pretty much every investment,” Fisher said.
“People always complain about how hard our job is as investors, and don’t get me wrong it is hard, but when interest rates are going down it’s actually pretty easy to make money.
“Diversification, to some extent, didn’t quite matter as much as you might have thought it would because everything was going up, bonds did well, equities did well, everything does well when rates go down.”
The problem is when rates go the other way.
“Then everything does quite poorly and that’s what we found at the back end of 2021 and into 2022. As interest rates started to go up what we found is pretty much every asset in the portfolio was starting to bring prices downwards,” Fisher said.
“This is why we invest in alternative assets and why we think these are important elements in the portfolio, because in a year like that having access to diversifying asset classes can insulate our portfolio to some extent.”
The Inflation Link
Private assets tend to show a smoother return profile as they are not subject to the daily fluctuations of the stock market. Their valuations are often priced on a quarterly basis, although in Australia the regulator has indicated it would like to see this happen more often.
Yet, valuation methods are not the only characteristic of private assets. Fisher points out they also tend to outperform over the very long term, partly because many of these assets generate income linked to inflation.
If you look at the really long-term performance of each of the unlisted asset classes at Australian Retirement Trust – so, property, infrastructure and private equity – then what stands out is the relatively smooth path of returns, but the other element is that they do actually outperform over time
“If you look at the really long-term performance of each of the unlisted asset classes at Australian Retirement Trust – so, property, infrastructure and private equity – then what stands out is the relatively smooth path of returns, but the other element is that they do actually outperform over time,” he said.
“It doesn’t mean they always work. In 2020, for example, you can see property and infrastructure facing quite a challenging environment, not surprising when those were the assets that were some of the most impacted throughout COVID-19 and were shut down in many cases.”
But over the past 12 months, property and infrastructure have done relatively well again due to their inflation-linked nature.
“You don’t get that same inflation linkage through the public markets,” Fisher said.
The Case of Amplitel
In late 2021, before interest rates started to rise, ART invested in Amplitel, the mobile phone network for Telstra, under a joint venture arrangement with the telecom giant.
Although interest rates hadn’t yet moved, ART had the view rates were not going to stay low forever. The fund expected they would go back up to a long-term level of around five per cent.
With this in mind, the team discounted the future cash flows in their valuation of the asset, ending up with a lower price.
Yet, the revenues for the tower network were inflation linked and so income held up well when inflation started to rise, while many other investors started to look for similar assets.
“In an inflationary environment, inflation-linked cash flows are really attractive. After inflation starts to move, everybody wants to get themselves exposed to things like this and so prices will get elevated a little bit as well. So all those factors combined allowed us to deliver a 10 per cent-plus return in an inflationary, rising rate environment,” Fisher says.
“That is a case study in how diversification works and why we put assets like this in our portfolio.”
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