Are you where you need to be?

Transcription

1 Are you where you need to be? Russell Investments Annual Investment Summit 15 November

2 Wall of Worry or Slope of Hope? Andrew Pease Markets today For the past year it feels that we ve been climbing the wall of worry. Markets have had a lot to overcome yet they have powered through- are we about to shift from climbing up the wall of worry to falling off the slope of hope? There are five things we know about markets today; US economic expansion is old; Lots of asset classes are expensive; No signs of Euphoria yet margin debt hasn t surged; Recession Indicators are still muted; Central banks have shifted away from expansionary measures. Thanks to our cycle, value and sentiment process, we are able to devise several different scenarios showing what markets might look like over the next 18 months. Central scenario Our US strategist anticipates that we will see the Fed hike rates three times next year. If that does indeed happen, the yield curve will flatten and second half of 2018 that should provide some big headwinds for markets, given that bear markets usually begin around 6 months before recessions. Boom scenario In the event that the Fed behaves more dovishly and keeps rate hikes down, market euphoria could take hold. In this scenario, the dollar will remain weak, which will be particularly beneficial for emerging markets. Gloom scenario Finally, if the Fed behaves aggressively and overtightens interest rates, or if R* turns out to be very low, the US could be at risk of recession in late Markets would probably sniff this out by mid-2018.

3 Confessions of a portfolio manager David Vickers Confession #1: I am beset to behavioural bias Having been through several bear markets, David has had his fair share of scares. As such, he openly admits to being a cautious investor. Two women have shaped his career- his mother and the queen. They taught him to revaluate what success really means ultimately, it is achieving the clients required rate of return and a crucial part of this is preserving the real value of capital. Today, David looks beyond simply beating the benchmark and seeks to mitigate drawdowns and exploit the power of compounding. Confession #2: There are some events we simply can t predict It seems like hardly a day goes by when we are not bombarded with a geopolitical crisis or a war of words. The trouble is, this noisy newsflow can sometimes get in the way of making sensible investment decisions. Using our cycle, value and sentiment process, we look at the probabilities and potential consequences of an event. This removes the noise, and makes us re-focus on the fundamentals. You can t quality control the investment outcomes, but you can quality control the investment decision process. Confession#3: Only one future will come to pass but many are possible Market declines are always obvious with hindsight. But, crashes exist precisely because they are unexpected and cannot be forecasted in a very timely manner. Aside from valuations, we use check posts to help determine whether risks are increasing or rescinding: corporate behaviour, profitability metrics, balance sheets and credit metrics and positioning. It s likely that you won t spot the turning point, and that should be accepted but a good process should have you leaning out of risk assets as returns come down and risks rise.

4 Portfolio construction for the 21 st century Ronnie Sabel and Fons Lute Zero-sum game It s widely considered that active management is a zero-sum game. Few investors are still persuaded for active management, and many throw in the towel for passive management. We, however, don t think the situation is so bleak. There are concepts that are useful in understanding the merits in active management in particular, the active share. Strategic positioning At Russell Investments, we think that the key to alpha is in controlling the data. We monitor over 13,000 managers and put them through our robust research process. Using data analytics and meetings, we narrow the universe down until we can find the best-in-class managers for our portfolios. But crucially, we look for the best combinations of managers for returns over the long term i.e. strategic positioning. Our approach to this is factor investing which looks 6 different factors: value, momentum, quality, volatility, growth and size. Factor, active and passive In our team, we broadly favour value, quality and momentum. But, the reality is, we can t just select 3 managers that specialise in each factor, slot them into a portfolio and be done with it. Instead, managers must be looked at holistically; for example, which percentage of each factor might they be exposed to? We select the best managers, often with high active share, blend them together, apply individual weightings and finally, look at the overall portfolio reviewing the factor weighting. This last step allows us to review the overall factor weight and either add another manager to fill the gap or use passive positioning strategies to provide the desired exposures.. The last step allows us to decide whether we add another manager to fill the gap or if we add in the missing exposures ourselves, but in a passive way. Together, this approach ensures that our portfolios combine all of the elements of factor, active and passive investing in our view, that s portfolio construction for the 21 st century.

5 Anti-gravity in multi-asset portfolios Thomas McDonald Gravity and anti-gravity Investors today have to contend with the dual gravitational pull of it being very late in the economic cycle with high global equity valuations. However, these are longer term fundamental drivers. For the short term at least it seems as though markets are defying gravity. Why? Well Tom thinks it is because of two factors: the Return Imperative and the Fear Of Missing Out (FOMO). The Return Imperative refers to investors need to achieve their static return objectives and a reliance on models which force them further and further out on the risk curve. FOMO in an investment context is the way investors have been conditioned to aggressively buy the dip since the financial crisis, leading to overconfidence and other behavioural biases. As a consequence, the path of least resistance for markets, at least in the short term, appears to be higher. Over the long term, as we know, the outlook is gloomy due to the gravity of extreme valuations. Fortunately for savvy investors, there are means of building in anti-gravity to make portfolios more resilient to shocks whilst preserving any remaining upside capture. So, what s the solution? Investors should seek to build in positive asymmetry and effectively try to replicate the payoff profile of a call option, using new and existing components within their existing multiasset portfolio. For example, an investor could consider these following three strategies: 1. Favour assets that have built-in convexity such as convertible bonds. 2. Adopting a value orientation within asset classes like currency 3. Reduce exposure to asset classes that exhibit a high probability of left tail outcome i.e. high yield bonds

6 Cashflow driven investing David Rae Cashflow negativity Everyone is talking about cashflow negativity (i.e. pensions payments exceeding the contributions). Evolving demographics and scheme closures have been the driving force of this. Only 15% of UK pension schemes are currently open and only 12% of members are active. While this is a global phenomenon, it has been exacerbated in the UK by the impact of the freedoms and choice changes of Cashflow negativity will increase over time. Most employers would prefer to pay less into defined benefit schemes and benefit payments will increase. However for now, cashflows are manageable and most schemes are some way off from reaching their point of peak cash outflow. Our concern with the cashflow driven investing (CDI) solutions that are being proposed at the moment, is that they are addressing the issue from the wrong perspective. Rather than trying to start with the needs and circumstances of the pension scheme, they are starting with the product and asset class set. Looking at risk There is much to be gained by looking at risk through the cashflow lens. However, that doesn t mean CDI solutions should immediately replace our more traditional approach of looking at the funding level risk measures. In the early stage of repairing deficits and managing funding levels, there may be very limited value in looking at cashflow risk measures. But, as the certainty of meeting the cashflows increases and there is greater predictability, it makes more sense to give greater weight to measures of cashflow risk and the probability of paying all pensions when due. Crucially, CDI is not a panacea. Anyone presenting you a solution that solves all your problems probably hasn t done enough work looking in detail at the challenges you face. Remember, CDI is a risk framework, not a product.

7 Incorporating ESG for better outcomes Will Pearce and Adam Smears Environmental, social and governance (ESG) issues Neither a day goes by without a headline about ESG but, to what extent do these issues really impact investment returns? We believe that ESG is not a fleeting fad, it is here to stay. However, it is a challenging issue to address. One of the reasons why is because ESG changes depending on who you speak as values are in the eye of the beholder. We ve identified four types of ESG solutions that clients want: exclusions based; engagement based; single issue and broad based ESG. Responsible investing beliefs In order to help us provide responsible investment solutions to this wide set of demands, we have four beliefs: 1. ESG factors impact security prices. These can vary by company, industry and region, and their importance can vary through time. 2. A deep understanding of how ESG factors impact security prices is valueadding to a skillful investment process. 3. Embedding ESG considerations into a firm s culture and processes improves the likelihood of prolonged and successful investing. 4. Active ownership of securities is an effective tool for improving investment outcomes. ESG evaluation metrics ESG metrics are embedded into our ratings of investment managers. Solutions are managed so that they deliver on both financial and non-financial goals over the long term. We believe that active ownership and stewardship is a fundamental part of this.

8 Making currency risk rewarding Ian Battye, Van Luu, Jihan Diolosa Return opportunities We are seeing more and more investors recognise the return opportunities available with currencies. Currency risk shouldn t be entirely dismissed, but investors should be more conscious of the total portfolio impact. Further to this, we actively advocate that they should take on currency exposures that either add to total portfolio return or diversify total portfolio risk. For example, in many of our fiduciary mandates, we are closely managing the exposure of foreign currencies versus sterling. In our Multi-Asset Growth Strategy, our portfolio managers were able to add significant return by dynamically managing foreign currency exposure around the Brexit referendum. Dynamic currency hedging In general, we believe that a dynamic currency hedging approach allows us to capture the international equity premium more efficiently than static hedging. Designed to address the embedded currency risk in the total portfolio, dynamic hedging manages the home currency risk, but a focus on added return. Rather than maintaining a static hedge ratio, such as 50%, dynamic hedging means that the currency hedge ratio can change over time adjusting to the market environment. Sterling hedge? For instance, today we expect that sterling will not fall much further and has the potential to recover longer-term. In light of this, it is far more attractive to hedge sterling now than it was pre-brexit. So, for sterling-based investors who are not already hedged, it s a good time to start thinking about it. If sterling does indeed increase from here, it could erode your returns. For those who are already hedged, it would be worth consider a more dynamic approach and increasing your hedge ratio.

9 The multiple faces of credit risk James Mitchell and Adam Smears 4 faces of credit risk Many investors just focus on volatility but credit risk manifests itself in four main forms: volatility, drawdown, impairment and reinvestment risk. When investing in credit to capture the credit risk premium there are two main investment approaches which have different approaches to managing these risks. 1. Prioritise yield and return potential These are multi-asset credit (MAC) strategies which are typically fully invested as they look to maximise return. In terms of credit risk - the main focus is guarding against impairment risk/defaults. Diversification is key here. We think investors should diversify across the main balance sheets: personal, corporate and sovereign. Many MAC strategy providers just focus on the corporate balance sheet, but there are other areas of the market where you can capture the premium, diversify your portfolio, and reduce impairment risk. One needs to hire specialists in each of these areas though. Another way to enhance your returns is to focus on less efficient sectors such as fallen angels investments grade (IG) bonds that have fallen on bad times and have been downgraded to high yield. 2. Prioritise risk management over return potential For more risk-averse investors, unconstrained bond strategies prioritise risk management and try and mitigate all four dimensions of risk. To protect against credit impairment, investors can diversify within credit but also get exposure to other risk premia such as prepayment risk. In order to limit drawdown risk, one can get exposure to long volatility strategies that tend to perform well when credit isn t. Within credit one can also focus on shorter dated credit which will help mitigate drawdown risk. Unconstrained strategies are also typically quite active in asset allocation and cash management and this can guard against re-investment risk. Managing all these risks can lead to a give-up in return potential but leads to better risk adjusted returns. solution.

10 For Professional Clients Only. Unless otherwise specified, Russell Investments is the source of all data. All information contained in this material is current at the time of issue and, to the best of our knowledge, accurate. Any opinion expressed is that of Russell Investments, is not a statement of fact, is subject to change and does not constitute investment advice. The value of investments and the income from them can fall as well as rise and is not guaranteed. You may not get back the amount originally invested. Issued by Russell Investments Limited. Company No Registered in England and Wales with registered office at: Rex House, 10 Regent Street, London SW1Y 4PE. Telephone Authorised and regulated by the Financial Conduct Authority, 25 The North Colonnade, Canary Wharf, London E14 5HS. UKI Expires: November ???. 10