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Conservative investors must accept lower returns

Lewis Jackson  |  01 Sep 2021Text size  Decrease  Increase  |  
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Conservative investors need to learn to live with lower returns in an era of low interest rates, according to a portfolio manager at one of Australia's largest superannuation funds.

Managers were sounding the alarm over the disappearance of traditional defensive returns at the Australian Institute of Superannuation Trustees annual conference Tuesday.

Decades of falling interest rates have squeezed the returns out of fixed interest and cash, and investor’s must adjust their return expectations to match the regime change in markets, says Leanne Taylor, head of asset allocation and portfolio construction at Cbus Super.

“We have lowered our investment objectives on our diversified options to what we think is a more realistic level given what has happening in asset markets,” she says.

“We believe that’s a more prudent approach, rather than increasing the risk within your portfolio. If you have a conservative portfolio, then I think it’s prudent to stay true to label.”

The Cbus conservative option targets 1% per annum plus inflation over a rolling 10-year period and has over 55% of the portfolio in fixed interest and cash assets. This follows Cbus' 2020 decision to reduce return targets for its Conservative option by 0.5%, from 1.75% to 1.25% above inflation.

The most conservative option at Australia’s largest superannuation fund AustralianSuper aims for 1.5% above inflation over the medium term.

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In this new environment, investors need to get clearer about what they want from their defensive assets says Taylor. Some investors want assets that move in the opposite direction to stocks, others assets that remain stable in downturns.

Seen this way, cash and bonds continue to give portfolios downside protection and flexibility even if they no longer provide high returns, says Sebastian Mullins, fund manager, multi-asset at Schroders.

For example, negative yielding German government bonds rallied 5% when equity markets crashed last March, and cash gives investors flexibility to adjust their portfolios as market conditions change.

In a changing market environment, investors need to stay alert to how once familiar relationships between asset classes, such as equities and bonds, can change, says Mullins.

“If you look back at history, government bonds were the best hedge ever but looking forward that’s likely behind us now,” he says.

Super funds look to currency and infrastructure

The search for defensive assets had fund managers talking up the value of foreign currency exposure and physical assets as alternate ways to build defensiveness into portfolios in a world where cash and bonds are out of favour.

In periods of market stress, the Australian dollar tends to fall versus the American greenback as investors move money to the safety of the US. For Australian investors holding US equities, this currency appreciation can cushion the fall in asset values.

“We like holding the US dollar and Yen because that gives you nice downside protection for equity market crashes,” says Mullins.

Defensiveness can also be built into portfolios with essential physical assets such as farmland, toll roads and energy infrastructure, says Biff Ourso, senior managing director of Nuveen Real Assets.

Many of these infrastructure assets are already in private hands and super funds in search of stable returns are swarming around the few that remain on public exchanges.

This month Sydney Airport (ASX: SYD) beat back a bid from two Canadian pension funds while the board of Spark Infrastructure (ASX: SKI) has recommended shareholders accept a bid from a consortium including several Australian super funds.

The most conservative options at Cbus Super and Australian Super have a 7% and 11% allocation to infrastructure, respectively.

Inflation looms

Investors grappling with the future of today's low intertest rate environment should look back to the 1950s and 1960s, according to several analysts speaking at a market outlook panel earlier in the day.

During this period, the US government and central bank kept rates artificially low to make it easier to service debts left over from the world war and make it easier for the private sector to borrow. In the 1960s, spending soared as President Johnson launched social welfare programs at home and the Vietnam War abroad.

Today, an overhang of Covid-19 debt and new spending on climate change could create similar incentives for governments to artificially maintain low rates, says Carol Austin, board director at State Super.

“I think that the environment that we are likely to see going forward is more like what we saw in the 1960s,” she says.

“It didn't end well in the 1970s with soaring inflation. And I think we risk the possibility of an extended period of artificially low interest rates, giving rise to an unfortunate correction.”

Between 1950 and 1979, the real annualised return of long duration US government bonds was -1.69% as inflation exceeded returns. Things changed between 1980 in 2019, where steadily falling interest rates boosted annualised real returns to 5.64%.

But with interest rates now scraping along the bottom and equity market valuations sky high, investors need to accept an era of higher risk and lower returns, says David Neal, chief executive at IFM investors.

Parts of the market are now in “speculative” territory now says Neal, pointing to the boom in Special Purpose Acquisition Vehicles (SPACs), valuations that require years of double-digit growth and a rise in investors using stock options to bet on the market rising.

The Australian and US markets are 11% and 6% overvalued, respectively, according to the Morningstar market valuation estimate.

“I’m a proponent of Stein’s law—if something cannot go on forever, it will stop,” says Neal.

is a reporter and data journalist with Morningstar. Tweet him @lewjackk or get in touch via email

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