In February last year a great investment opportunity arose. Actual US inflation year on year was rising rapidly and oil and growth were starting to recover. But US TIPS – inflation-linked bonds that protect again inflation – weren’t priced to reflect that increase. TIPS remained historically cheap relative to nominal bonds and offered both a compelling investment return and an effective hedge against unexpected inflation appearing.
To take this opportunity, however, investors needed to recognise and isolate just the future inflation component of the US inflation-linked securities. It was a potentially complicated move that could have left the investor with either unwanted exposures, or unnecessary cost.
With the end of Quantitative Easing (QE) advisers know they must increasing look beyond traditional assets and strategies. They know they must incorporate more flexible and sophisticated tactics -- like the TIPS trade -- if they are to generate decent returns and help clients reach their financial goals.
There is a danger, however, that by trying to implement these strategies themselves they become distracted from their key role: building relationships with clients. But if advisers can understand that there are three capabilities, particularly, that are more suited to outsourcing to dedicated investment managers, they are more likely to avoid putting their vital client relationships at risk.
Dynamic asset allocation
The first capability that is suited to outsourcing is dynamic asset allocation (DAA), which is always relevant, but becoming increasingly important as QE ends.
QE has provided a tailwind for all the major asset classes such as equities and bonds, and a fixed, set-and-forget strategic asset allocation (SAA), therefore, performed well. But the shift from QE to quantitative tightening (QT) will see returns from asset classes vary much more significantly and investors will need greater flexibility.
DAA is one of the best ways to respond to uncertain markets because it actively shifts the portfolio away from underperforming assets, which not only helps manage risk but also provides the potential for outperformance.
Financial planners can obviously attempt a more dynamic investment strategy. But they are unlikely to be able to implement DAA as effectively or in as structured a fashion as a dedicated investment team who is closely tracking market movements.
Implementing DAA also raises major client-management challenges. Markets are dynamic and ever-changing, particularly in this environment. Yet an adviser may only meet with a client once every year or a most every six months. Markets aren’t going to wait for a particularly client review.
A second capability suitable for outsourcing is the use of alternative investments, which are also becoming vital in this market.
QE has major asset classes like bonds at record highs and has significantly pushed down their return outlook. In this low-return environment, investors will need to access alternative investments and strategies that generate returns independent of the market.
There are many different types of alternative strategies including ‘event driven’, ‘merger arbitrage’ and hedge fund replacement strategies. The key is to access truly diversified alternative strategies: strategies that truly diversify away from the likes of equities and credit risk premiums.
Unfortunately, access to many of the best alternative strategies is only available to institutional investors. Advisers can’t access many of these alternative investments on retail platforms because the range is much narrower.
Alternative strategies are also expensive. A large investor like AMP Capital with significant scale can access alternative strategies for a fraction of the cost of retail platforms. Whilst advisers can attempt to replicate some alternative strategies, it is complex and costly, and requires deep understanding of the strategies and effective resources, such as global trading capability, to implement.
Hedging and derivatives
Finally, the use of complex hedging and derivative strategies to protect clients from unexpected and potentially devastating market falls is also a strong candidate for outsourcing.
As Nader Naeimi recently noted, Quantitative Easing (QE) suppressed volatility. Whenever markets sold off, investors assumed central banks would intervene. Falls were regarded as buying opportunities. But with QE turning to QT (quantitative tightening), that inherent downside protection ends. Volatility will increase as will the probability of share sell-offs.
Those sell-offs are particularly devastating for clients in retirement, or close to retirement who face ‘sequencing risk’. A 50 per cent portfolio loss requires a 100 per cent return to recover. But if retirees are drawing down their capital for living expenses, a smaller amount of capital will be exposed to that recovery.
To protect against that risk, investors will need to incorporate hedges into strategies. The market at present offers opportunities to mitigate downside risk, particularly as the level of volatility is very low (options are cheaper when volatility is low).
It is important, however, to be selective about which markets that protection is bought in, and how the positions are structured. When buying protection, it must be bought for some specified length of time of time, and the price premium for downside protection out into the future generally tends to rise very quickly.
Given the complexity of executing these hedging strategies, advisers may be better advised to outsource it to an investment manager with a dedicated team experienced in hedging strategies.
Focusing on their true edge
There is no doubt that the new investment environment is challenging and requires increasingly integrated and flexible strategies and tactics, such as DAA, alternatives and hedging, to generate robust returns.
Advisers do have the capability rise to the challenge. But there is a strong argument for leaving it to asset managers – particularly goals-based funds - with focused teams who can monitor markets closely for opportunities, but whom also have the scale to access a wider range of options and access them cheaply.
Rather than getting lost in a haze of market minutiae, and lost in tactics like mispriced TIPS, by leaving it to asset managers, advisers will be free to focus on the most important aspect of their business: developing deep and rich relationships with their clients.
While every care has been taken in the preparation of this article, AMP Capital Investors Limited (ABN 59 001 777 591, AFSL 232497) and AMP Capital Funds Management Limited (ABN 15 159 557 721, AFSL 426455) (AMP Capital) makes no representations or warranties as to the accuracy or completeness of any statement in it including, without limitation, any forecasts. Past performance is not a reliable indicator of future performance. This article has been prepared for the purpose of providing general information, without taking account of any particular investor’s objectives, financial situation or needs. An investor should, before making any investment decisions, consider the appropriateness of the information in this article, and seek professional advice, having regard to the investor’s objectives, financial situation and needs. This article is solely for the use of the party to whom it is provided and must not be provided to any other person or entity without the express written consent of AMP Capital.