Focus on risk-adjusted returns, not the market's latest shiny toy

There’s huge ambivalence in financial markets at the moment, driven by a range of things. Is inflation going to pick up? How quickly will COVID vaccines be distributed and accepted by populations? Will the recovery continue?

Despite this, equities keep pushing higher. Year-to-date, the S&P500 has gained almost 12%. Closer to home, the ASX200 is up 9% over this period.

For investors, it seems there are more questions than answers. But we’ve distilled what we believe are some of the most important concerns right now and run them past Anthony Murphy, CEO of wealth manager Lucerne Investment Partners.

In the following interview, he explains how he and his team are thinking about investment portfolios now. 

Anthony Murphy

CEO

Lucerne Investment Partners

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What are the most important trends for investors to watch in the years ahead?

I think it's probably more important to first consider what trends to avoid. What you're seeing in the market at the moment is a lot of hubris and euphoria. And as a result of that, investors are trying to chase the latest trend - for example, Dogecoin! You are seeing a lot of herd mentality which will likely lead to disaster once the stampede goes over the cliff. The recent Livewire interview with Jeremy Grantham summarised this well.

Macro

Grantham: This is a bubble, this is serious

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Bond yields have already started to increase, which highlights markets are pricing in the cost of capital increasing, which then puts pressure on equity markets particularly companies relying on liquid capital markets in order to remain solvent. Markets are obviously nervous.

Janet Yellen, US secretary of the Treasury recently said: “...it may be that interest rates will have to rise somewhat to make sure that our economy doesn’t overheat”, which caused markets to sell off aggressively. Half an hour later she rolled back her comments to try and restore order.

So, one trend in equity markets we think investors should follow at the moment is to seek companies that continue to demonstrate very strong balance sheets and P&L’s, and that are carrying low levels of debt as a rising cost of capital will put pressure on margins.

We suggest investors move away from companies that are highly reliant on strong liquidity in primary markets and focus more on the traditional stayers in portfolios that have survived through the test of time in all market conditions. There's a bit of a rotation back into Australian banks which have been doing very well at the moment, and a rotation back into some of the consumer staple companies like the Woolworths (ASX: WOW) of this world doing well with strong margins in their business. Some other areas of the market that will be well-supported would be resources, infrastructure (an easy spend for governments), and also healthcare companies positioned to benefit from the post-pandemic environment.

We're seeing that traditional value and income portfolio managers are really starting to pick up the slack, whilst the growth managers that had stellar 2020s, have started to see a revaluation in a number of their companies. Afterpay (ASX: APT) has seen its price lose 45% in three months, and is a bellwether of what's going on in the market. I put that purely down to the market rationalising.

What’s the toughest part of being a wealth manager in the current environment, where we see such high volatility in a late-stage bull market, but where such strong returns have featured as markets have bounced back?

Markets could rally for another 12 to 24 months, but we see the potential for a pretty significant rerating or correction from these levels if economies don't live up to the hype. A lot of good news is baked into elevated valuations at a time that any one of a number of risks could trip over the recovery narrative.

So the big challenge is dealing with investor expectations and ensuring that you don't go off and chase the next shiny toy in the market and focus instead on seeking high-quality, risk-adjusted returns.

"Risk-adjusted" may be an overused term, but it is important for investors to ask themselves if they are actually being compensated with appropriate returns for the level of risk they are taking, given the stage of the cycle we are in. In the current environment, a lot of investors seem to be ignoring risk for return, and adopting such an attitude often ends badly.

Right now we feel like we can get reasonably strong returns across the alternative space without having to take a lot of equity market risk. And that's a challenge with investors in itself because educating an investor on the benefits of an alternative strategy is more challenging than a traditional ‘buy-CBA’ strategy at the moment

We all know the market has been through countless cycles before, but as human beings, we never seem to learn. So we find the challenge is about placing a cap on investor expectations, and if we have to leave something on the table for someone else, in order to preserve capital and take less risk in this market, that's our strong preference.

Can you explain your process for setting asset allocations?

One thing that we're really focused on at the moment is taking less traditional equity market exposure over the next few years in favour of alternative exposure. We're doing this either via long-short equities, resources, or the re-emerging gold trend that we're seeing in the market.

We feel that there's still quite a large gap in risk-adjusted returns between equities and private debt. We think we can get relatively predictable returns at the moment around 6.5% - 7.5% with a tremendous amount of security, in the form of lending against bricks and mortar. And when compared to cash, this is an excellent risk-adjusted return, particularly in the context of inflation.

On a weighting size at the moment, our traditional, domestic and international, long-only equity market exposure, would be no more than 25 to 30%. That's for investors that are comfortable with that level of risk, while others will be around the 10 to 15% mark. So, one still has ~70% of the portfolio to allocate and at the moment, we would say 30 - 40% of that goes into alternatives and that's resources, that's long-short funds, that's precious metals, that's arbitrage funds, that's momentum funds, that's quantitative funds. Everything outside of your traditional long-only market.

And then in addition to that, as I mentioned before, it's a decent allocation to private debt or credit and income where the majority of the time we have security over a fixed asset, and that can be a portfolio approach or whether it's one of our preferred investment specialists or an asset in itself directly.

We like to design asset allocation to suit the investor because whether we like it or not, what we tend to find is that risk profiles do tend to change throughout the market cycle. One should in theory have the same risk profile, regardless of downside or upside, but emotions get in the way of that psychology so we tend to have quite a fluid approach to asset class allocation.

You’ve mentioned before you allocate to co-investments as well, can you explain what that means?

One thing that we look to do is actually co-invest with some of those managers we allocate to. So for example, one fund at the moment we really like is Keyview Flagship Fund (previously Realside Capital Flagship Fund), a private debt fund that we're supporting. A number of opportunities that have come into their environment of late are appealing. We have the ability to introduce our clients directly and some will select some of their best transactions and co-invest alongside the fund. That's something that we've done for the last five years, and those types of transactions can really move the dial for investors.

Another co-investment that we supported recently was Wimp 2 Warrior. It's a really interesting investment that plays on the F45 / Crossfit thematic, but in mixed martial arts, whereby the Wimp 2 Warrior program is integrated into primarily single occupied gyms, martial arts gyms or boxing gyms. It allows individuals to learn not only the basics but how to effectively fight in mixed martial arts, which is the third most-watched sport in the world now, behind soccer and basketball. So it's a huge fan following, it's over 600 million worldwide at the moment.

It was founded by Nick Langton, ex-wealth management finance specialist out of Sydney and also Conor McGregor's coach, John Kavanagh. We invested via a convertible note giving our investors protection on the downside, but still being able to capture most of the equity upside as well. Since we invested in the last few months it has gone from strength to strength.

How do you find and vet fund managers to ensure they meet your criteria?

We review all funds according to a defined and rigorous process, but five aspects we consider as part of our initial checklist would include:

1. How are they different, and what is their competitive advantage?
2. Is there a defined process (...and do they stick to it)?
3. Performance - and how they will keep delivering it
4. How long would it take to head for the exits?
5. How transparent are they?

We wrote about this in more detail in a previous Livewire article, How to find the next CSL of fund managers. In that piece, we also explained why we also like to find managers that set a hard limit for the fund size, are focused on protecting capital and invest with their clients, or

‘Capacity constraints, Capital preservation, and Co-alignment’ as we like to call it.

In terms of where we find new opportunities, it can be anywhere. It could be a client saying, "Hey, have you looked at these?" It can be a cap intro firm. It can be another fund manager that we support saying, "You should see what these guys are doing, it's interesting." It can be through a hedge fund database. We monitor all the usual channels but are open to ideas from right across our networks. Of late, we have received a number of inbound enquiries from emerging managers given the success of our fund of funds approach to investing.

An additional point to make is to watch for overcrowding in certain themes. Initial success in one place can lead to others looking to jump on the bandwagon and is important to identify who the real talent is. While Regal and Perennial were some of the first to establish the private-to-public theme, that space is becoming increasingly popular and potentially crowded. We are seeing a similar thing unfold in the Crypto assets theme as well - there are plenty of frauds emerging in "Crypto land".

Could you tell us about some fund managers you’ve invested in recently whose strategies look particularly promising in your eyes? Why are you so interested in them? Please talk us through the due diligence you undertook.

One thing that's really paramount to us is that our underlying investment managers have a lot of flexibility in their mandates, where they can be opportunistic and take advantage of asset prices should they fall. And so we're looking at strategies that have mandates from 3-7 years at the moment. Ultimately, some of those strategies might end up doing better if there is a correction than if markets continue rising.

One example that really holds to that is a manager called HEAL Partners, which stands for health, education, and lifestyle, three thematics with significant tailwinds behind them. What HEAL Partners looks for are businesses that are global, repeatable and scalable. It raised about $70 million in a strategy that's going to be capped at around $100 million.

One of its recent asset investments, which we're very interested in, is a tattoo removal business called Removery which started in the US and is growing globally. It'd be fair to say a lot of people out there are going to regret their tattoos, and as a result, the numbers behind the business are astronomical. HEAL got in before renowned Elliot Funds Management did who wrote a $50 million check into this business.

Another thing to look for in fund managers at the moment is whether they’ve been through a few market cycles. The HEAL team has and they've proven themselves time and time again. Their average IRR on investments is in excess of 40%, and their target IRR in this fund is 30%. To do that, one has to be very selective in the types of assets they'll invest in and recently out of the 90 opportunities that were shown last year, they picked one for investment.

One other one we like is the Altor Alpha Fund, an event-driven strategy focused on smaller companies. One thing that really resonated with us when we first met chief portfolio manager David McNamee, was his commitment to hard-closing that strategy at $30 million. That is incredibly small for a fund in any field, however, having a small amount of capital to manage allows him to be incredibly nimble, and he is focused on performance over scale and wants the fund to serve as a flagship fund under his stewardship.

We became involved in mid-2020, and true to his word he hard-closed the fund at ~$30 million at the end of last year. The fund has now returned over 330% since inception (March 2019) and David has built a strong following in the market. Something we like is the flexibility in the mandate, whereby last year on the back of some incredible performance, took his cash position up to ~35% as markets started to become overpriced. David is happy to be patient with capital at the moment, which we encourage, and look for opportunities as they present. 

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Lucerne Investment Partners offers tailored investment solutions for high-net-worth investors. Please click 'CONTACT' to speak with us.