The New Abnormal for Portfolio Management

The market environment has changed.  Yet most advisers’ portfolios have not.  They may want to adapt fast if they want their clients better suited to the new market environment - assuming they’re not going to unduly suffer more weak returns going forward as they did in 2018. 

Many portfolios probably won’t adapt fast enough, and their clients will suffer.  Of course, many institutional investment funds haven’t and probably won’t do well either given their institutional rigidities and commitment to traditional ‘strategic’ asset allocations (read: reliance on what previously worked - ever lower interest rates and rising equity markets - still working).

What happened in 2018?

2018 should be well understood by now.  In brief, it was a very difficult market environment for nearly every investment approach with several crucial lessons!  Returns were poor and disappointments from passive and active managers were the norm, with many, if not most managers discrediting themselves completely in the last quarter of the year, when markets really became challenging.   Risk assets started to question their very foundations and made it clearly known that they can’t withstand tighter financial conditions, even with a growing global economy! 

This is far from promising for the future, as once you closely examine the foundations and fundamentals of our current unproductive debt driven economic framework – upon which risk assets depend - you realise that it appears entirely unsustainable.  We are extremely vulnerable to a prolonged bear market in risk assets and credit market deterioration, and obviously to the next/upcoming recession in most major economies. 

Simply put, there is too much debt and too many claims on future economic growth, genuine productive growth is minuscule, and the size of the financial economy has grown enormously compared to the size of the real economy, to the point where the tail now wags the dog.  Wall Street didn’t fix the unproductive debt problem from the GFC – instead major governments added to it and created the foundations of the populist movements we see worldwide today!  This is getting increasingly hard to continue with. 

When will the broader market wake up to this and stop buying the “short term fix” i.e. the next central bank supportive policy, or unsustainable government fiscal stimulus?  When will the castle made of sand disintegrate?  Watch out for when and if it does, as it could be a sudden collapse.  Of course, one can’t say that this will happen now, but unfortunately it appears increasingly likely to happen within a timeframe that most of us care about and are investing for.  That hence matters a great deal to portfolio management for those who care about risk management - as many if not most of the entire bull market gains could easily disappear, as easily as one writes a 0 on this page. 

In 2018, investors have once again suffered once again at the hands of the politicians and central bankers, who didn’t get ‘it’ either, and couldn’t seem to get their messaging right, constantly backtracking as the market told them they had it wrong.  This wrecked numerous investment strategies in the process as many investment approaches simply don’t or can’t account for these factors, and investors were forced to risk manage their positions and consider the massive uncertainties.  Once again, the technocrats have highlighted what a politically and policy dependent market we are in.  This means that your average equity dependent portfolio is almost entirely dependent from here on what political and policy outcomes eventuate, and is hence extremely binary in nature.  This is not what investors buying individual assets want, particularly if they are biased to fundamental bottom-up long only managers as so many are.

Why does it matter?

The extremely binary nature of mainstream asset classes (such as equity, property and credit markets) is a key point to take account of.  If we are building outcome-based portfolios – and we all should be - we can’t and shouldn’t tolerate a single indeterminate factor determining whether we reach our investment goals or not. We don’t want our long-term investment results entirely determined by whether the world somehow finds a way to successfully exit from its easy policy driven, unproductive debt expansion debacle which has resulted in a “bubble in everything”.  We want portfolios that don’t risk massive wealth destruction in the process of necessary global changes, as the unsustainable becomes just that. 

Our problem is – while the exact timing is unknown - it is hard to see how the excessive financialization of economies renormalises successfully without major and very serious portfolio challenges.  It is easy to see how the aim of all is to continue to kick the can down the road – or to ignore the challenges altogether - but hard to see how this is sustainable policy.  It is very easy to see that a backlash of the disenfranchised (i.e. most people) has started and that increasingly populist politicians and technocrats will ultimately make further wealth destroying and short-term vote buying decisions, and how this probably ultimately needs to come at the expense of capital (i.e. your assets!). 

What can one do?

The world is a much risker place than most people dare to admit, and much riskier than how typical portfolios are positioned and would suggest it is. We’re truly managing portfolios in a new abnormal!  This is not a ‘normal cycle where you know you’ll bounce out the other side with your “strategic” long biased portfolios intact and capable of easy recovery to their prior highs.   There is a reason why policy makers can’t stand the idea of a recession apart from the general lack of appreciation of the benefits of a recession cleaning up the unproductive.  We’re too deep in to an artificially created mess of a system.  Prior policy decisions and short term orientated and self-orientated societal ‘values’ have set us on an ugly path.

As advisers, you need to make sure you understand the enormity of the challenges we face.  As investors and as clients of advisers, you need to make sure your adviser ‘gets it’ and is at least facing the challenges head-on without saying “she’ll be right mate” or looking in the rear-view mirror.  What are you doing differently?

Investors in general may have to be much better diversified and potentially more defensively positioned than they would otherwise be.  They typically need much greater use of diversifying assets and investment strategies.  These may include lower beta approaches, greater monitoring, due diligence and reaction times, dynamic risk management and portfolio construction, genuinely value adding active managers, and greater use of diversifying and proven alternative management approaches in lieu of long only managers.  Liquidity will be important.  All of this is research and resource intensive, and much is deeply knowledge intensive and skill based.  All of it costs money and can’t be done well, if at all, on the cheap.  Many advisers will have to change what they do and how they do it and be prepared to spend resources on what matters - including whole of portfolio decisions and better quality research and understanding of market conditions – rather than what is simply accessible and easy to do.  Old biases and approaches and the “cheap and cheerful” will no longer cut it. 

Don’t expect poor numbers in 2018 to be a one-off rear-view mirror event if you don’t make meaningful change in response to the enormity of the continuing and upcoming challenges.  As Darwin suggested, it is not the strongest that survives, but the most willing to adapt to change.

Important Notice

Jerome Lander is Managing Director of boutique investment firm Procapital and an Authorised Representative of Harvest Lane Capital Pty Limited AFSL No. 425334, which manages the Harvest Lane Absolute Return Fund. This communication is for informational purposes only and is a thought piece which represents the views of the author alone. It is not intended as an offer for the purchase or sale of any financial instrument. It does not constitute personal or formal advice of any kind and should not be relied upon as such – investors should consult their financial advisers before making any investment decision. This article’s accuracy cannot be assured. All opinions and views expressed constitute judgment as of the date of writing and may change at any time without notice and without obligation