IMCO CEO Bert Clark on Investing in Challenging Times
Bert was kind enough to forward me a paper on investing in challenging times which formed the basis for his fireside chat earlier today:
Investing isn’t easy. There are no immutable laws of investing. There are no hard and fast rules, only probabilities, and much of that is beyond an investor’s control.
The big unknowns of any era are ultimately resolved and in retrospect they look logical and even predictable. As a result, every investor probably thinks they are living in challenging times.
Like previous environments, today’s investment landscape is characterized by many unknowns that make investing challenging. While there are no silver bullet techniques for navigating market challenges, there are well-known and straightforward strategies that have generated better returns over the long term. These include: Diversification, liquidity management, targeted pursuit of net value add, cost control, sound risk management and navigation of big trends.
At IMCO, these are the strategies we follow.
THE CHALLENGE OF INVESTING TODAY
To put things into context, here are the things that make investing challenging today.
First, markets are being driven by central bank activity. Twenty years ago, central banks influenced short-term interest rates, had very small balance sheets and made intentionally vague public statements about the future path of short-term interest rates. They also had narrow mandates generally, focusing primarily on stable inflation (and for some, a dual mandate that also included full employment).
Today, the U.S. Federal Reserve balance sheet is bigger than many of the largest asset managers in the world and it directly influences the market on bond pricing across the entire interest curve. The Fed is not alone. For over a decade, the European Central Bank, the Bank of Japan and the Bank of Canada have consistently affected capital markets in what were referred to as “unorthodox” ways.
Today, central banks are also being relied on to pursue a broader implicit mandate: Ensuring the smooth operation of capital markets (especially in times of crisis), keeping market volatility in check, and preventing major market corrections. There is also talk of expanding their formal mandate to include public policy considerations, such as climate change.
While central banks are powerful, they are not all-seeing and all-powerful. It worries me when they pursue multiple goals and when they are deeply engaged in the capital markets because investors are then dependent on central bankers getting many things right.
Ultimately, central banks will need to anticipate the second order impacts of their intervention: What happens if extended intervention in the capital markets makes all asset classes expensive? How do they withdraw massive monetary stimulus without deflating the value of all assets? What if monetary policy exacerbates inequality? What if it leads to poor allocation of capital? What happens if it encourages spendthrift fiscal policy?
Central banks will need to reconcile many public policy objectives, second order effects and externalities in one mechanism – interest rates. That is not going to be easy.
The second challenge is that we are at the intersection of two powerful trends: A lower-for-longer interest rate and growth environment and above average short-term inflation and growth.
Coming into the COVID-19 Pandemic we appeared to be stuck in a lower-for-longer environment. Debt, demographics, inequality, and technology all seemed to be weighing on interest rates and growth in the largest economies. These are powerful forces, which aren’t easy to overcome, as central banks had been priming the pump to an extraordinary extent for a decade. COVID has done nothing to reverse these phenomena, in fact, it has probably reinforced them. Society is now more unequal, older, and more in debt, while the technology sector got a big boost from consumer and business behaviours adopted during the pandemic.
However, the combination of extraordinarily large government spending, coupled with a global wave of central bank stimulus measures, along with a bounce back from the steep contraction in employment, growth, and inflation last year, is giving rise to higher growth and inflation (at least, in the U.S. and China).
If you consider these two divergent trends, it’s not obvious which one will dominate. Therefore, we are starting to see a debate around the benefits and risks of continued fiscal and monetary stimulus. Are we coming out of a recession and bouncing back to a lower-for-longer return environment? Or, is rising inflation the start of a coming period of sustained growth and monetary and fiscal policy risks overheating the economy?
A third challenge for investors today is that years of unorthodox monetary policy may not have managed to stoke inflation, but it did manage to drive down the risk premiums for almost all classes. So, today almost all asset classes are expensive by historical standards. All other things being equal, higher starting valuations lead to lower returns and investors therefore need to be concerned about returns over the coming decade.
The compression of risk premiums complicates things for investors in one other important way. It has pushed investors into riskier asset mixes, by making it more expensive to own government bonds. The combination of less government bonds and lower risk premiums across all asset classes means that the typical investor’s portfolio is more susceptible to inflation (government bonds are already starting at negative real yields) and deflation (larger allocations by most investors to riskier assets provides them with less protection from deflation). In other words, most investor portfolios will perform well in a narrower range of circumstances than in the past.
No doubt, investors also face other challenges: The impact of technology, the path of globalization, the continuing rise of China and its relationship with the U.S., the ongoing impact of the COV ID-19 Pandemic, and inequality. But, in my view, the distortion of asset prices by central banks, the intersection of longer-term deflationary trends and short-term inflationary trends, coupled with the high price of all asset classes are the most critical.
KEY INVESTMENT STRATEGIES
It is not possible to completely outsmart or outrun the challenges of any era. But I believe there are straightforward investment strategies that improve risk-adjusted returns over the long term, through a range of investment environments.
ASSET CLASS DIVERSIFICATION
I believe that the most important investment strategy is diversification.
In an ideal world, diversification would mean building a portfolio that could perform equally well in all macro-economic environments.
But most investors can’t afford to have significant portions of their portfolios invested in nominal and inflation-linked government bonds, especially today. The expected return of the portfolio would be too low. To meet their long-term investment objectives,most investors have portfolios that are dominated by allocations to assets that are riskier than government bonds (e.g., public and private equity, credit, infrastructure, and real estate). This kind of portfolio should generate higher returns over the long term than a perfectly diversified portfolio with a larger allocation to government bonds (at least it has in most, but not all decades). But it will not perform well in all macro-economic environments. It will tend to perform best in periods of growth and stable inflation, and it will not perform as well in periods of deflation or stagflation.
As a result, for most investors, diversification means accepting they have a portfolio that is heavily titled to riskier assets but still working hard to avoid significant concentrations in any one riskier asset class, or any one country; and not overdoing any of the common return enhancing strategies (such as investing in private assets or using leverage).
ENSURING ADEQUATE LIQUIDITY
You can’t be a long-term investor if you are forced to sell riskier assets in times of market strain.
Many investors have portfolios that are dominated by riskier assets to enhance their potential returns. Riskier assets are priced to generate higher returns over the long term, in comparison to investments like government bonds, to compensate for their near-term price volatility. But this means you need to be able to hold on to those riskier assets through periods of volatility. Proper liquidity management ensures you can do this.Proper liquidity management also allows you to rebalance in times of market stress, which can be one of the simplest and most powerful ways to profit from the volatility of riskier assets.
TARGETED PURSUIT OF NET VALUE ADD
Net value add means outperforming market indexes. Numerous studies have confirmed just how rare this is in the asset management industry.
Despite the preoccupation of the asset management industry with net value add, often there are more straightforward ways to increase returns, than trying to accurately predict winners within each asset class. Sometimes, an investor would be better off, on a risk-adjusted basis, simply altering their asset mix to include more risky assets (if they are diversifying) or adding a small amount of leverage, if they are interested in increasing returns and are comfortable adding risk.
However, if an asset manager does want to generate outperformance within asset classes (this is an entirely legitimate objective, especially where you have some advantage) and they believe they are able to do this in a way that is more efficient from a risk-adjusted basis than simply adding risk assets to their asset mix or a small amount of leverage, then success requires focus.
Focus means investing such that outperformance or underperformance will matter. That takes courage. It means not spreading your bets at the asset class level too thin. It means having conviction around each of your investments because if you place bets that are too small within an asset class, you will end up with what famed investor and philanthropist, Peter Lynch called“diversification”: A multiplicity of investments that when taken together looks a lot like the index and generates average results.
Focus also means pursuing outperformance where you have an actual competitive advantage. This could be a longer investment time horizon, a tolerance for complexity, an ability to serve as a capital partner and work with companies in which you invest, or the ability to hire best-in-class specialist investors on cost-efficient terms.
Costs are one of the few things you can control as an investor; and costs matter even more when you are operating in an environment of potentially lower returns.
Today the so-called “2 and 20” fee structure that is common for private assets and hedge funds results in fees that are very large in relation to expected returns for most asset classes. This common cost structure was developed in an investment environment where returns were much higher than they are expected to be going forward. But the fee structure has not evolved and paying these kinds of fees makes it very hard to achieve satisfactory net returns.
When possible, investors should avoid fund of funds structures. They should use their scale to negotiate preferable fee arrangements. They should co-invest alongside their private asset managers. They should also selectively internalize activities (where they can achieve the same investment results at less cost).
MAINTAINING SOUND RISK MANAGEMENT
At IMCO, our approach to risk management has three elements.
First, we only invest in things we can understand, measure and monitor.
Second, we are investors not speculators, as there is an important distinction between these two things. Investors allocate capital to productive initiatives that are designed to generate returns through ingenuity and hard work. While investors hope to buy at a good price, their investment thesis is not primarily dependent on short-term market movements. On the other hand, speculators look to earn returns exclusively by correctly anticipating near-term changes in the market. This is very hard to do and it’s something we generally avoid.
Third, we follow best practices when it comes to risk management. In many cases, this means looking to other segments of the financial services sector for ideas, such as banking and insurance.
NAVIGATING BIG TRENDS
Finally, we believe that it is important to have the discipline to act on big trends.
The challenge for large institutional investors is having the discipline to evolve to reflect a changing world. Leading asset managers are no different than the best companies in other sectors. The best run companies aren’t necessarily the ones with unique insights who are way ahead of the pack. They are the ones that leverage their natural advantages and have the discipline to adapt their large and diverse operations and investments to reflect big powerful and well-known trends. In other words, it is just as much about hard work and discipline, as it is about unique insights.
For example, the most successful car companies will be those than make the transition to electric vehicles. The most successful technology companies will be those that adapt to the cloud and other technology trends, like blockchain. The challenge is not identifying the phenomenon of electrification, or the cloud or blockchain, but rather of adapting to them.
At IMCO, we are spending lots of time thinking about the ways we need to adapt our clients’ portfolios to powerful and well-recognized trends.
For example, we are adapting our organization to respond to the set of powerful changes across the investing and policy spectrum often referred to as Environmental, Social and Governance (ESG).
We believe that better governed, more inclusive, and diverse organizations, with a plan around a less carbon-intensive future, will perform better and represent better investment opportunities for us. But making sure our clients’ portfolios reflect these beliefs requires a considerable amount of work.
ESG beliefs need to be embedded in all investment activities: How you choose managers, make individual investments, benchmark performance, invest passively, vote proxies, report, and set goals around sustainable investments. Right now, we are in the midst of making sure all our investment activities reflect our beliefs around ESG.
While investing isn’t easy, it doesn’t need to be made more complicated.
It becomes less complicated if you accept that most eras are dominated by one or more big unknowns and there are no sufficiently reliable ways to predict how those unknowns will play out. Ideally, you should be comfortable with those unknowns playing out in a range of ways.
Today, the three most important unknowns are the impact of ongoing central bank involvement in the markets, the intersection of powerful deflationary and inflationary trends and the high price of most asset classes, especially bonds.
The best overall strategy is to make sure you can live with these unknowns and stick to the straightforward strategies, which have been shown to generate better performance, including diversification, liquidity management, very targeted investment strategies, cost efficiency, sound risk management and navigating big trends through a range of environments.
These strategies are known to most, but the challenge is to have the discipline, and to do the hard work required to consistently follow these strategies. It is simple, but not easy.
What a fantastic comment from Bert Clark, I read it twice to absorb all the great insights he provides here and I thank him for sharing this with me.
I used to allocate to the top hedge fund managers all over the wold and I have never read a paper like this. It's beyond thought-provoking, he explains the major structural and cyclical forces that make it very challenging for IMCO and all asset managers to invest in this environment.
I share Bert's concerns on expanded central bank intervention in financial markets and we touched upon it when I went over IMCO's 2020 results with him and Jean Michel, IMCO's CIO.
In short, central banks have adopted what Patrick De Roy, IMCO's Senior Managing Director, Total Portfolio & Capital Markets, calls an "ALL IN" approach.
Central banks all over the world are still fighting the deflation demon. Why? Because nothing scares Wall Street and elite hedge funds and private equity funds more than deflation. Once you're stuck in a protracted debt deflationary trap, it's almost impossible to get out of it.
This is why central banks keep talking down cyclical inflation ("it's transitory") and want to keep the pedal to the metal on asset purchases and keep rates lower for a lot longer.
But as I keep warning my readers, central banks can only create asset and housing inflation, not sustained inflation which comes from sustained wage gains.
Ironically, central banks' policies are exacerbating inequality, which is deflationary over the long run.
For example, the Fed is backstopping investment grade and high yield bond markets as part of its response to the pandemic. Large corporations emit billions in corporate debt, investors snap it up knowing the Fed is backstopping this market, and companies use that money to buy back shares to raise their earnings per share and reward their executives lavish executive compensation.
This is capitalism? This isn't capitalism, it's corporate welfarism/ cronyism at its worst.
Meanwhile, you have restaurants and many other small businesses shuttering, unable to make ends meet to make their rent and payroll and central banks aren't bailing them out (maybe indirectly and they do get some fiscal relief measures which only buys them some time).
Where am I going with this? Massive central bank intervention is distorting markets and it's exacerbating inequality.
Maybe this is the goal of these policies, namely, to concentrate wealth and power in the hands of fewer and fewer companies and tech and corporate moguls, but it has its limits and as Ray Dalio has warned, it will cause major social unrest.
Worse still, I am afraid that central banks are sowing the seeds of the next major deflationary crisis as asset values and housing prices go parabolic.
There's so much leverage in the system and I am not just talking about margin debt, I'm talking about total return swaps prime brokers extend to the Archegos of this world so they can quietly leverage up their equity positions (of course, Archegos is only the tip of the iceberg, many funds are doing the exact same thing to a lesser or equal extent).
What all this liquidity and leverage has done is send asset prices higher and higher and increased the risks for pensions and other asset managers.
In the background, you still have the inflation/ deflation debate I keep harping on.
In a recent comment on the marked improvement of US state pension plan funding, I didn't mince my words: “the risk of global deflation, not inflation, has never been higher than at any time over the last 10 or 20 years.”
"Come on Leo, everyone and their mother is warning of inflation!"
And, so what? I don't get excited by news headlines, I'm a thinker, I'm paid to think and think long and hard of the risks out there, and there are plenty.
Sure, the US economy will post great annualized GDP figures, inflation pressures are high, but what you really need to ask yourself is how sustainable is this?
The way I see it, the end will come in one of two scenarios:
- Either we get runaway inflation and high or low growth (stagflation) pushing rates up to levels that the economy and markets cannot support, forcing more central bank intervention.
- Or, we will see a deflationary crisis which will start in financial markets and spread to the real economy, bringing about massive unemployment. This too will force a lot more central bank intervention but the effects of additional monetary stimulus will be a lot more muted.
Of course, I'm reminded of what Ray Dalio told me back in 2005 when I was adamant that deleveraging/ deflation lies ahead: "What's your track record?"
Ray was forcing me to stop being a stubborn Greek and embrace the fact that nobody knows the future, so it's best to diversify all your risks.
This is what Bert Clark is also saying but he includes other things apart from diversification, like liquidity management, very targeted investment strategies, cost efficiency, sound risk management and navigating big trends through a range of environments.
By the way, one important way IMCO manages its liquidity is through bonds.
You want to increase your allocation to bonds when asset values are very frothy to prepare for the eventual sell-off to buy back assets when they are cheaper.
One thing is for sure, despite the historical low yields, bonds still play a critical part in the portfolios of pensions.
In fact, earlier this week, I read a Bloomberg article on how bonds beat stocks at pension funds, turning 60/40 inside out:
The debate over the traditional 60/40 portfolio seems endless, but for pensions at least, it’s over -- and bonds won.
The retirement funds of the top 100 U.S. public companies, with combined assets of about $1.8 trillion, have ratcheted up their fixed-income allocations to a record level. At the end of their last fiscal year, they held 50.2% of assets in debt, while slashing money parked in equities to an all-time low of 31.9%, according to a recent report from pension advisory firm Milliman Inc.
The shift, part of a longer-term transition spurred by federal legislation that made fixed-income more appealing, is gaining momentum even though asset class returns have gone in opposite directions with stocks surging to record highs while a four-decade rally in U.S. bonds is in jeopardy. Analysts see the emphasis on debt by the funds accelerating, and maybe most significant, potentially helping to blunt any move higher in yields.
“The big improvement in funding ratios implies a high incentive” for “U.S. private defined benefit pension plans to lock in the recent gains in their funding position by accelerating their de-risking going forward,” a team of JPMorgan Chase & Co. strategists including Nikolaos Panigirtzoglou wrote in a recent note. That means “accelerating their buying of long-dated bonds and selling of equities.”
Pension funds tend to follow a strategy of matching liabilities -- which are usually long term -- with similar maturity assets, usually debt. Even though rising yields can hurt returns in the short-run, they’re a plus since they can help reduce the present value costs of obligations.
Paltry yields that seemingly have nowhere to go but up have been an almost universal worry that has prompted investors to question the wisdom of sticking with the long-favored portfolio diversification recommendation of 60% stocks and 40% bonds.
Ten-year Treasury yields have risen over a percentage point since August, nearly reaching 1.8%, as an improved vaccine rollout sparks business reopenings amid trillions in fiscal stimulus. The jump in yields resulted in the worst quarter for Treasuries since 1980, and has prompted Wall Street to predict even higher yields before year-end. Meanwhile, the S&P 500 index climbed 5.8% in the three months ended in March, the fourth consecutive quarterly increase.
Until last quarter, it’s mostly been the best of both worlds for pension funds, with equities outperforming long-duration debt even as yields plunged over the past few years. That generated gains that exceeded increases in pension liabilities.
The funding status -- a measure of the degree to which pensions have enough assets to meet liabilities -- of the 100 companies tracked by Milliman was 88.4%. Since 2005, the funds have also increased their allocations to “other” investments including private equity, real estate, hedge funds and money market securities to 17.9% from 9.5%. The majority of the companies have a fiscal year end that coincides with the calendar year end.
“The main reason for the overall shift from equities into fixed income has had to do with the change in pension regulations,” said Zorast Wadia, a principal at Milliman. “And as these pensions’ funding status have improved they have continued to shed equity risk -- getting more and more into fixed income.”
Under the federal Pension Protection Act passed in 2006 companies had a set time to fully fund retirement plans and were required to use a specified market-based rate of return -- tied to corporate bond yields -- to compute liabilities rather than their own forecasts. This change made buying debt in an asset-liability matching framework more appealing than equities.
The American Rescue Plan Act of 2021, the most recent Covid-19 pandemic relief bill, provides two forms of general funding relief for single-employer pension plans. It’s not clear yet if that may affect asset allocation decisions.
JPMorgan predicts that public pension funds run by states and local governments are also on course to shift more into fixed income. These public defined benefit plans, with about $4.5 trillion in assets, have a funding status that trails their private-sector peers, at about 60%.
“So public pension funds have less incentive to de-risk in general,” Panigirtzoglou wrote. “But they do face a problem. Their equity allocation is already very high and their bond allocation stands at a record low of 20%. So, from an asset/liability mismatch point of view they are under some pressure to buy bonds.”
On the surface, any preference of fixed income makes little sense. Since 2005, the Bloomberg Barclays U.S. Aggregate Bond Index increased about 5% annually, about half the S&P 500’s return. But when adjusted for volatility, equity performance was 23% worse than bonds.
While optimism about the bull market in stocks seems endless, aversion among pension funds persists. This month, Bank of America Corp.’s pension fund clients have been net sellers of stocks, extending a year-long trend of outflows.
What corporate pension plans “are looking for is to be well funded, not necessarily to get strong returns,” said Adam Levine, investment director of Aberdeen Standard Investment’s client solutions group. “It is possible that as rates rise, corporate pensions move enough to the fixed income that to some degree it counters the rise in rates. You can certainly make that case if the moves are big enough and the industry is big enough.”
So, bonds aren't dead, at least not at US corporate plans and increasingly not at public pensions either even if they are taking more risks (they still need to manage their liquidity).
Alright, let me wrap it up there and thank IMCO's President and CEO Bert Clark for sharing his insights with me.
Please take the time to read his comment carefully, it's not an easy read but it's very well written and he elucidates the main challenges of investing in this challenging environment.
I will post the C.D. Howe Institute fireside chat with Bert if it becomes publicly available.
Below, a ACPM panel discussion featuring Patrick De Roy, Senior Managing Director, Total Portfolio & Capital Markets at IMCo; Eric Menzer, Global Head of OCIO and Fiduciary Solutions, Manulife Investment Management and Sadiq Adatia, Chief Investment Officer, Sun Life Global Investments. It was moderated by Zaheed Jiwani, CFA, Principal, Eckler (I discussed it earlier this week).