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Time for a ‘risk-on’ mindset

Dec 29 2016 14:01
Mariam Isa
Øyvind Schanke is the chief investment officer for

Øyvind Schanke is the chief investment officer for asset strategies at Norway's oil fund. (Picture: Supplied)

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Global financial markets are entering what is likely to be a sustained period of volatility created by unexpected and unsettling political events – Donald Trump’s US election victory, Britain’s exit from the EU, and the rise of right-wing populism in Europe.

These events and their aftermath have generated an unprecedented level of political and economic uncertainty which is likely to last for several years, making investment choices more difficult and their outcomes less predictable.

Asset managers are divided on whether this signals an end to the bull market in equities seen since the global financial crisis ended eight years ago, although there is a prevailing view that investors should expect lower yields in many asset classes.

Most believe that the rise of “passive investment” in indexed mutual funds and exchange-traded funds (ETFs) will continue as these offer hard-pressed retail investors lower fee costs and less punitive tax implications.

However, they all argue – perhaps predictably – that active investment strategies as well will be essential as trends seen over the past few years end and interest rates climb in the US. Trump’s promises of sweeping tax cuts, and of $1tr of infrastructure spending have spurred anticipation that growth in the world’s biggest economy will accelerate, lifting the global economy as a whole.

In its latest economic outlook at the end of last month, the Organisation for Economic Cooperation and Development (OECD) predicted that US growth will quicken to 2.3% next year and 3.0% in 2018, boosting global growth to 3.3% and 3.6% respectively in those years. 

Uncertain times

However, there is also concern about how easily Trump, the businessman turned politician, will achieve his aims – and trepidation over the possibility of trade wars as he withdraws from long-standing global agreements and complains about the strength of China’s currency.

In Europe, the fallout from Brexit will make itself felt for years to come and the continent is braced for the rise of right-wing political leaders as populations rebel against government austerity and the influx of millions of immigrants into their countries.

There is even a very real risk that other countries will leave the EU. This process kicked off on 4 December, when the Italians voted against constitutional reform. This had led to the resignation and dissolution of Italy’s government, triggering a political crisis and possibly an election.

On the same day, however,  there was a re-run of Austria’s presidential election after a knife-edge result in May was cancelled due to voting irregularities. This time,  Norbert Hofer of the country’s right-wing Freedom Party was defeated by his Green Party opponent, Alexander Van der Bellen. Hofer had promised to call a referendum on EU membership if Turkey is granted accession or if Brussels consolidates more power.

In France, National Front leader Marine Le Pen could emerge victorious after first and second rounds in April and May. She also has a strong Eurosceptic and anti-Islam stance – worrying for the country’s large Muslim population – and has pledged to hold a referendum on France’s membership of the EU.

Far-right Dutch leader Geert Wilders – who is being tried for hate speech and discrimination, is nonetheless tipped to become Netherlands’ next prime minister after an election in March. He has also vowed to call a referendum on Dutch EU membership and to end immigration from Muslim countries.

In keeping with the pattern, Germany may be confronted with a shock federal election outcome in September 2017, when Angela Merkel runs for a fourth term as chancellor in the face of competition from the anti-EU Alternative for Germany.

“Trump’s election victory has changed the geopolitical and investment landscape for the next multiple years and was a wake-up call for politicians everywhere,” says Old Mutual investment director Hywel George. “Broad populations won’t stand for more austerity and quantitative easing has broadly failed in terms of ordinary people.”

Shift away from accommodative monetary policy

Economic policy will shift its emphasis from monetary to fiscal expansion to meet a pro-growth agenda, which will add up to an investment world that will benefit equities, particularly small-cap companies, along with emerging- and frontier-asset markets, he says. “Investors must get into a risk-on mindset, which they are not in at the moment. Equity markets will go up but continue to be very volatile,” he adds.

Analysts are quick to point out that rising interest rates do not mean lower equity returns, as the opposite has often been the case in the past. Economic trends across the world are more divergent than they have ever been and this requires investors to think differently, they maintain.

But agreement appears to end there – many asset managers believe that equities are riskier than ever as valuations are so high, making the market ripe for a correction.

“The world is set up for disappointment,” says Marius Oberholzer, head of Absolute Return at Stanlib. “I’m not predicting a big crash – there are always opportunities in asset markets. People must stretch their nets as wide as possible but be mindful that risk is elevated in equity markets right now.”

Passive investments

This is where a heated debate kicks in over whether to invest with expensive asset managers who try to beat the market, or put money into a “passive” mutual or ETF which seeks to track, rather than surpass, an investment benchmark. The benchmark could be a share index, fixed income securities, commodities, foreign exchange, a particular sector of the economy, or derivatives – among others.

Estimates vary, but according to investment management giant Vanguard Group, the average cost for passively managed funds is 0.18% versus 0.78% for actively managed funds, virtually all of which are mutual funds. ETF fees are on average about 0.35 percentage points, according to other data, while hedge funds are much more expensive, charging an average of 1.5% on assets managed and nearly 19% on profits generated.

ETFs are more tax efficient than mutual funds, because they don’t have to distribute capital gains to investors when they sell securities – which is particularly important against a global background of rising capital gains tax rates. 

They are also more flexible as they allow intraday trading, while mutual funds can only be traded when their net asset value is calculated at the end of the day.

This helps to explain the huge migration of capital away from actively managed equity funds and into ETFs. Data provider Morningstar says that assets managed in passive mutual funds have grown four times faster globally than traditional active products since 2007. They now amount to $6tr – but are still dwarfed by active asset funds of $24tr. Assets in the ETF industry alone are estimated at $3.2tr, having overtaken the $2.97tr held in hedge funds.  

According to research by Stanlib there has also been an exponential rise in passive unit trusts and ETFs in South Africa over the past few years, although their entry into domestic markets lagged their global appearance by about two decades. In the first six months of this year, South Africans bought R5bn worth of ETFs – the same amount as in the whole of 2015, which was up from just over R3bn in 2014 and R1bn in 2013.

“It’s not about stock-picking anymore,” says Leonard Jordaan, head of distribution at Stanlib Index Trackers. “We think there’s value to be had for an investment professional to construct a portfolio which makes use of passive building blocks.”

Investors should find a solution that blends both active and passive funds to free up their fee and risk budget, which could then be allocated to higher conviction active managers, giving them the best of both worlds, George maintains. 

Underperforming asset managers 

In October, figures released by S&P Dow Jones showed that the huge shift in asset allocation was justified – almost all actively managed US, global and emerging market funds had failed to outperform stock market indexes since 2006.

The evidence has reinforced criticism of the asset management industry, which is now widely perceived to be overcharging its clients at times of poor returns.

In an investigation concluded in November, Britain’s financial watchdog, the Financial Conduct Authority, said it had found “there is no clear relationship between price and performance”. 

Margins at asset management firms had stuck at around 36% over the past six years – regardless of market swings – while managers clustered around the same prices for their services, telling the FCA that competition on fees seldom brought in new business. 

At the same time, more than half of ordinary investors in the UK were unaware that they were paying fund charges and six in 10 had never switched to a new provider.

Nonetheless, many asset managers believe passive investing is not appropriate at this point in time. Informed choices had to be made as the performance of individual stocks varies more and the generous returns seen across asset classes over the past few years come to an end, says Investec Asset Management fund manager Rhynhardt Roodt. 

“The industry has been guilty of crying wolf too soon, as the bull market has lasted longer. Today is the right time to cry wolf,” Roodt said.

Investments had to shift into cyclical sectors which offered value rather than quality, and active managers could do better, he maintains. Investors would have to be brave, choosing cheaper companies priced at a discount to the market.

Other asset managers predict that cyclical sectors that could do well in the wake of a US economic upturn fuelled by Trump’s policies include infrastructure, construction, manufacturing and housing, while US banks could put in a better performance in a more relaxed regulatory environment. 

Decline in equity 

There has been mounting concern over a sharp decline in the amount of stock in circulation after a steady wave of takeovers, mergers, share buybacks and delisting – coupled with a decline in the number of Initial Public Offerings.

Øyvind Schanke, chief investment officer for asset strategies at Norway’s $880bn oil fund, told the Financial Times last month that countries with a higher rate of listed companies on average had a better pace of growth and public listings gave people the benefits of that trend.

But other managers say the world is changing, and the decline in IPOs is understandable. Many innovative companies were frustrated with the short-term mindset of investors and had easy access to capital outside of equity markets, George says.

Crowdfunding is playing an ever increasing role in raising private capital, with platforms generating an estimated $2.1bn for start-ups in the US alone last year – and the amount could double in 2016 as investors hunt for better returns.

Mariam Isa is a freelance journalist who came to SA in 2000 as chief financial correspondent for Reuters news agency after working in the Middle East, the UK and Sweden, covering topics ranging from war to oil, as well as politics and economics. She joined Business Day as economics editor in 2007 and left in 2014 to write on a wider range of subjects for several publications in SA and in the UK.

This article originally appeared in the 15 December edition of finweek. Buy and download the magazine here.

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