Thursday, 24 March 2016

We’ve talked before about the low expected return environment we believe we’re likely to be operating in over the coming years, including the reasons for it.  On this blog we haven’t yet discussed in any detail the implications of this, and what we are doing about it.   And this is the topic of this post.

Firstly, the low expected return environment is likely to bring with it a higher-risk environment.  In combination, these two factors will make it harder for investors to achieve their return objectives, be that a super fund or a fund manager, or an individual.  The low expected return environment reflects the current extremely low cash rates globally (including in Australia) as governments continue to grapple with the consequences wrought on their economies by the GFC.  Low cash rates tend to be associated with lower inflation rates and lower returns to assets such as bonds and shares, making it harder to achieve portfolio return targets. In short, we believe the risk-return relationship of investing in financial markets has deteriorated and this has prompted us to reposition the portfolio over the last few years.

Let’s set the scene.  Between 1990 and 2007, Australian inflation (consumer price index or CPI1) averaged 2.8 per cent per annum meaning QSuper’s Balanced Investment option’s average annual return target (CPI + 4 per cent over this timeframe) was 6.8 per cent2.  The Reserve Bank of Australia’s cash rate averaged 6.4 per cent over this time, so to meet the return target the risky assets in the portfolio needed to return a mere 0.4 per cent on average each year (if you take the cash rate to approximate the risk free rate3). 

This was fairly straightforward given global shares returned 6.8 per cent per annum  on average over that time, and Australian bond yields averaged a whopping 7 per cent.  Roll forward a few years, and things are much different. Today, although  QSuper’s Balanced Investment option’s return objective was lowered to CPI + 3.5 per cent (after fees and taxes) in 2013 (partly in recognition of the lower return environment), annual inflation is running at only 1.7 per cent (meaning the portfolio’s return target is 5.2 per cent) while the local cash rate is 2 per cent. This means that the risky assets of our portfolio now need to deliver returns of 3.2 per cent per annum on average for the return objective to be met. It might not sound like a lot but over the past year, global shares are up a meagre 0.2 per cent, and the Australian long-term bond yield is 2.4 per cent. The table below might make things easier to follow1.


  CPI Inflation
 (annual)
QSuper's Balanced
Investment Option
Return Objective
Return Objective RBA Cash Rate Required Risk Asset
Returns
Global Shares
Returns
10 Year Bond
Yield
Average 1990 - 2007  2.8% CPI+4.0% 6.8% 6.4% 0.4% 6.8% 7.0%
Today 1.7% CPI+3.5% 5.2% 2.0% 3.2% 0.2% 2.4%


And this is not just impacting QSuper, but all investors, including other super funds, mum and dad investors, self-managed super fund members and big fund managers. Each has the same low cash-rate starting point.

So how are we positioning the QSuper portfolio? For us, there is a short- to medium-term focus and a longer-term anchor.  Following a disciplined process, shorter-term asset allocation changes are conditional on market pricing (not market timing).  We are primarily contrarian (or countercyclical) investors, focussed on prices and valuations: as these rise too far beyond what we consider ‘fair’, we reduce exposure to an asset class (and vice versa).  Consider the recent volatile market environment.  Steep falls in share prices over the past few months led us to increase our exposure to shares, believing these now offer better value than previously.  Over the medium-term, however, say the past four to five years, we have been reducing our overall global shares exposure since valuations have moved from being ‘cheap’ in 2010 to being  ‘expensive’ today.

Over the longer term, our concerns over lower expected returns and higher risk have led us to make key changes to the composition of our portfolio to improve its overall diversification.  We have done this in two main ways. First, we have offset the reduction in share market exposure with higher allocations to property and infrastructure assets, which tend to behave like shares over the cycle albeit with lower volatility.  Second, we have increased our exposure to sovereign bonds, which have also been re-structured to behave more like shares, although we have retained their vital share market diversification properties.

So, in response to our expectation of an altered future financial market landscape, we have fundamentally changed the asset allocation of the QSuper portfolio in such a way that, irrespective of underlying economic conditions, its returns should be more stable over the longer run.  And this level of protection comes over and above our disciplined process that sees us continually examining the risks in the portfolio on a daily basis, and altering asset allocations accordingly if conditions warrant.  


1. All CPI, cash rate and asset return data is sourced from Bloomberg.

2. This information relates to the QSuper Balanced option for the Accumulation account.

3. In theory the risk-free rate of return represents the interest an investor would expect from a risk-free investment over a specified time frame. In practice, the risk-free rate does not exist because even the safest investments carry a very small amount of risk. The cash rate or a short-dated government bond are often taken to represent a ‘risk-free rate’.

The views of the author and those who provide the responses to comments posted on this blog are not necessarily the views of the QSuper Board. We’ve put this information together as general information only and you should get professional advice before relying on this information.

Past performance is not a reliable indicator of future performance. Each of our investment options has a different objective, risk profile, and asset allocation.