The angst in Europe has calmed down, relatively speaking, but according to Mercer, it will be a long haul, with deleveraging there and in the US taking many years. Investors need to act accordingly.
Part of the problem is that conventionally safe assets, such as US Treasuries, are expensive.
“That will take years to work through and investors need to work assets hard in different ways. For example bond investors need to look outside of the core to a broader range such as private markets, anything that produces an income,” Mercer’s global chief investment officer, Andrew Kirton, says. “This requires thinking more creatively to behave more dynamically.”
Kirton believes there is a role for specialist managers in unique asset classes such as high-yield bonds or private markets, and Mercer has invested in boosting its research coverage of alternatives.
A decade ago bond investing was relatively straightforward, Kirton says, now there is a new product or investment strategy every month.
“It’s a very exciting time. While it remains a challenging time, it is not without opportunity.”
Kirton is encouraging clients to think laterally, to get out of their comfort zone.
“I say to investors they need to be prepared to look at assets that are less familiar to them.”
The biggest mistake investors can make is to lose sight of their objectives, Kirton says.
“Keep a careful eye on the risks to not achieving your objectives in a world where there will be more shocks,” he says. “Look at risk-management issues and the journey you’re on.”
Global head of fixed income at Mercer, Paul Cavalier, says the safety of fixed income has been called into question.
This is especially so in credit markets but also sovereign debt, he says, adding while it is a mistake to call the asset class risk-free, it can still be branded least risk.
The three elements of fixed income
Mercer is advising that fixed-income portfolios need three elements, with the exposures to each varying according to each client’s individual needs.
- An absolute-return portfolio that looks at all types of fixed-income alpha.
- A core structure in the middle that includes government debt.
- Satellite investments, which include emerging-market debt, high-yield debt such as bank loans, and credit opportunities.
Beware the benchmark
One of the consequences of the upheaval is investors need to be more cognisant of the benchmark composition.
“Over the past few years benchmarks have come into question, first in credit then in sovereign. In credit, financials represent 40 per cent of the benchmark, which is a large percentage, but financial credit operates differently to industrials. Investors have to understand what they’re getting into.”
The result is that indices are being split, and customised portfolios, such as credit ex-financials, are being built. This happened in equities 20 years ago, he says.
The inherent volatility can be observed by looking at yield levels on indices, Cavalier says.
“In December 2006 the global aggregate index was yielding 4.25 per cent and the US Treasuries 5 per cent; in December 2011 the global aggregate index was yielding 2.25 per cent and the US Treasuries 1 per cent. Is that what people expected?” he says.
“Further, during that period the emerging-market sovereign-debt local-currency index has traded at between 6 and 8 per cent the entire time, so there is a bubble in the risk-free assets.”
Cavalier is a proponent of an emerging-market debt allocation and says there is better value in emerging-market debt than developed-market debt, pointing to better growth, better debt to GDP and ratings upgrades.
“In the developed world the downgrades are outpacing the upgrades, but last year in emerging markets there were 17 upgrades and only 3 downgrades. All indicators favour emerging markets,” he says.
It is Cavalier’s view that fixed-income exposures should not be organised by regional diversification, but different asset classes, with the liquidity premium more important than ever, especially in credit.
“Dynamic asset allocation needs to focus also on illiquid markets – private debt, for example – and giving up liquidity for long-term return. Banks are out, now institutional investors play a role as patient capital.”
Cavalier, who managed money for an asset management firm for 22 years, advises investors to consider specialist managers rather than generalists who can do everything.
Asset management is not a profession he envies in the current environment: “I’m glad I’m a consultant not an asset manager at the moment, I can take a step back.”
