Lucerne look past equities bubble to stabilise returns

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Livewire Markets

Record low interest rates are doing strange things to markets. They’ve driven 12 consecutive monthly gains in Australian shares as investors buy YAAP (Yield At Any Price). And they’ve caused the market value of digital coins featuring a picture of a puppy to exceed the worth of ANZ Bank.

While many have been lulled into believing TINA (There Is No Alternative) to equities in the quest for returns, Lucerne’s Anthony Murphy and Michael Houghton are not having a bar of it. With the risks of rising inflation and financial lunancy coming undone, the portfolio managers have been busy figuring out ways to decouple from equity markets.

“Just look at the greats of the investment world at the moment," Murphy says. "The Buffetts and Dalios have been sitting on cash – they’re not going to play this game of herd mentality; of being sucked into the market.”

In this wire, Murphy and Houghton share their concerns about the current state of markets,  why they’re trying to reduce their alternatives strategy’s correlation to stocks and touch on where they're finding other opportunities for returns.


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Edited transcript

AM:

Good afternoon to our Livewire audience. This afternoon I'm joined by Michael Houghton,  Chairman of the Lucerne Alternative Investments Fund.

At Lucerne, we believe that investors' capital is best aligned to independent fund managers. At our core, we partner our investors' capital with both domestic fund managers and those abroad.

MH:

Hi, Anthony, given the extended lockdowns in Melbourne and Sydney, there's still a very rosy outlook for what's going to happen once those lockdowns are lifted, particularly around supply chains, asset prices, and employment. What's Lucerne's view on that?

AM:

It's a great question, Michael. I think it's on everybody's lips at the moment, the ones who actually do it, come out of lockdown, well, what does the world look like?

In some respects, it's quite ironic that, while we're in the midst of lockdown, particularly last year in Melbourne, we both experienced that, that markets were booming and, and everybody thought, how good was this? Particularly with the amount of stimulus that was being pumped into the economies around the world by central banks.

The ironic thing now is, if you look at consumer confidence, particularly on a global basis across China, across the US, across Europe, and across Asia/Pacific, consumer confidence is sliding. Yet if we look at the Northern Hemisphere, most of those economies are now open and people are freely travelling around Europe and the US.

I find this is quite an interesting, I guess, inflexion point, as we move out of lockdown, will businesses be able to, I guess, get back to where they were previously? That's one thing that our government's obviously banking on, and hoping will be the case.

I think, from a lifestyle perspective, we're going to see that pick up again in hospitality. We saw that last time in tourism, that as soon as we were released from our cages, so to speak, we were able to freely travel. We were able to go to restaurants, you have to make bookings.

But if we think about businesses as a whole, well, where we've had this safety net over the last 18 months, that the governments have more or less had to provide to our businesses out there, and large corporates, once those safety nets are removed, well, where are we positioned? That is the scary thought, and that's probably why we're seeing that winding consumer confidence.

There are some other scary statistics out there at the moment. Only last Monday, Livewire posted in their daily incredible stats, that if you look at the US economy as a whole, the US share market is now 2.1 times larger than the US economy.

For a point of reference, if you go back to 2009, pre-GFC, the market was 1.3 times the size of the US economy. If we go back to the.com boom and crash, it was 1.7 times. You use that statistic at the moment, things are quite hot.

We are in a bubble – many are saying that around the world. So we're approaching the world quite cautiously, at the moment, as a result.

MH:

Yet we've got this issue with inflation, and the debate that's raging around, both central banks, and through investors as well. Is it transitory, something that's just passing? Or is it something that we've got to be more concerned about as staying longer term, and something that we've got to manage too?

It's interesting that central banks are still behaving as if inflation is not a problem. They're not talking about raising interest rates. They're not talking about trying to manage those inflation targets that they set themselves.

We're seeing inflation, like in Australia, much higher than the band is at the moment, but there doesn't seem to be a lot of concern. That's something else that we've spoken a lot about, too.

AM:

Yeah. I think central banks at the moment, they, as you mentioned, inflation's a problem, and it's a problem that they're hoping that goes away. That word of the month at the moment, "transitionary," well, it seems to be the word of the month for the last three months.

If you think about investors, and where they're faced at the moment, 3.8% inflation, cash is paying 0.5, and central banks are going to keep interest rates low, as they said, for the next three to five years, potentially. So cash is 0.5, bonds at best are 2-3%, inflation's at 3.8, so your real return, after adjusting for inflation, is actually negative at the moment, on those defensive assets.

What does that mean? It's forcing investors into a very uncomfortable environment, where they're chasing equity market risk in order to maintain the lifestyle, particularly for super funds that are out there.

I guess that brings us onto another important part. So you take that sort of global macro view, well, what do you think that actually means for the economy, and then financial markets, on a go-forward basis?

MH:

That is the problem, I think, that we have to discuss and deliberate on, around what does happen with supply chains, as you touched on earlier. Prices for goods and services are spiking considerably. The cost of shipping is also up to 10 times higher than it was 12 months ago.

There's a lot of other factors that feed into the cost of production of goods and services that are only now starting to get priced in.

I don't think we've seen that impact individuals, consumers, businesses yet, and that's another consideration, that always, as we start to see that unfold, I think the transitory nature of inflation may very well become more permanent.

AM:

Absolutely, and then the other problem we've got going into, I guess, the winter in the Northern Hemisphere, we'd like to think with vaccination rates, that we're not going to see any more lockdowns in Northern Hemisphere. But then again, if you do have another variant of COVID-19, that's a variant that scientists and experts around the world are aware of, and vaccines aren't counterproductive against that, then there could be another lockdown in Europe and the US, and we hope that's not the case. But that's going to put more, further pressure on markets.

We only saw it was Monday of this week that the Wall Street giants came out and actually downgraded the US equity forecast in earnings.

I think, at the moment the market's gone from being in the very bullish period only months ago, literally, to now, everybody sort of sitting at this inflexion point, and wondering, "Where to from here?"

If you look at the Aussie share market itself, the ASX 200 since September last year has gone up every month. We've had 12 positive months in a row. The last time we experienced that was in 1943, I believe, it was. So it just gives you a real indication of the period that we're in.

You might fast forward five years from now, and we'll look back and say, "That was all easy, in hindsight." But when you're actually in the midst of where we are at the moment, it's this debate we're constantly having with the investors, that we continue to chase more equity market risks, to realise returns outside of those lower-yielding defensive asset classes, or other ways we can position portfolios at the moment.

MH:

You made a comment just then about where to from here? That does lead into another discussion that's been something that we've certainly talked about at Lucerne. That is that concept of there is no alternative – or TINA, it's called.

We believe there are alternatives, literally and figuratively. What sort of alternatives and what options should investors be considering in this market, where, you feel like you're compelled to follow a direction because that's where everybody is?

AM:

Yeah. I think it's pretty unfair to anyone out there named Tina as well, by the way, but ... And look, at the end of the day, as investors, what we're really guilty of doing, and sometimes right, and sometimes wrong, is when we think about investing.

If we're in a good position, we think, "Well, what's worked quite well for us for the last 10 years? Well, I'm just going to repeat that behaviour," particularly if you've had favourable outcomes.

Where the market is at the moment is in a really different period of what we experienced, historically. If you think about where interest rates are, they're on the canvas, so they can't go any lower.

While you've had new interest rates sliding since the GFC, and you might remember the RBA back in 2009 were able to cut the cash rate from seven to 3%, to stimulate growth. We went back up to 5.5% – now we're effectively at zero.

All those silver bullets that the RBA has had and the Fed Reserve in the US have now been used up.

What did you see last year, when we actually had the pandemic, and the market collapse, they had to use their other tool, and that was effectively to print.

Thirty percent of all US dollars were printed last year alone, which are now in global market circulation. So where does that take us, from a market perspective?

Well, if we're concerned that you basically had this artificial stimulus coming into the market from governments, governments can't kick that can down the road forever, which they have been doing for some period of time. But there will come a day of reckoning, and everybody knows the big short out there.

Michael Barry's been pretty outspoken in the media lately. He's quoted as saying that the longer the bubble goes on, then the harder the fall. Even Warren Buffett, as recently as two weeks ago, is now talking about an impending market crash. But then you've got the same problem that I mentioned before.

Cash is at 0.5, at best; bonds are at two to three. How does someone still make 5-6% on their portfolio, but don't want to have the exposure to equity market risk? If markets correct, they could fall sharply.

What I think's more likely when considering TINA, the alternative is, if you think about where markets are today, and we rewind back to 2015, what you saw over that calendar year was the market actually slid 17.5%, from January to December. Not a lot of people talk about that time, because everybody feels a crash much harder than a general market sell-off.

If you think about the market correcting over a period of time, circa 20%, I think that's very realistic, when there is actually mean reversion and an adjustment to earnings.

Then investors around the world start looking at markets from a fundamental basis. They probably realise that the US trading on 21 times P/E is not reasonable anymore.

So over time, investors' sentiment just changes. Everybody always talks about, "What causes the crash?" Yes, we saw the pandemic last year. The market was up 7% in January when we knew about COVID. But when the Western world got infected, in Italy and the US, that's when we saw that market correction.

What's interesting about that is if the market does start to slide, and re-base itself down to, say, 15-16 times earnings on a P/E basis, which is still around long-term average, if not slightly higher. Where do we turn from employing capital? And we're spoken about this a lot lately at the investment committee level.

From our perspective, where we think you can still generate good returns in the market is active management's now as important as ever. It's the first time, last financial year, in five years, where you had active managers actually across the board starting to outperform passive.

Whereas, the five years previously before that, just owning the market has served you. I guess I'd hand that over to you, from pockets of the market perspective, where are we looking to allocate capital at the moment, and the different strategies that we're employing within Lucerne to protect investor portfolios, but still be able to generate meaningful 8-12% per annum returns without being beholden to market risk as much?

MH:

I think that's an important observation to make is, rather than feel compelled to be allocated a certain way, because everybody else is, one of the key things that we discuss either at the investment committee or with our clients is: what is your return objective?

What are the objectives you've got, you have for investing, whether that be risk or return, types of assets you're prepared to hold or not hold, et cetera? You do that discovery process rather than say, "Well, everybody else is owning something, therefore you should, too."

AM:

Herd mentality.

MH:

Exactly.

From the point of view of the things that we're looking at within, the Lucerne Alternative Investments Fund, for example, we have a broad-based approach to the types of investments that we want to hold, based on what they do, with the objective of actually achieving what returns we think are viable for the risk that we're prepared to take.

One of the key things that we manage within the fund is its risk budget, if you like, and also the correlation of those returns to mainstream markets, as well as to the assets themselves.

We've been very successful at managing and keeping low correlations across assets, as well as to the market. In fact, our correlation continues to fall over the last 18 months to two years.

AM:

Yeah, correlation at the moment, across client portfolios, is the lowest that the market's ever been. We're running, on average, at about 0.5, whereas historically, we've been as high as 0.8.

The underlying principle of what we're trying to achieve is, particularly over the next 3-5 years, are equity-like returns. What I mean by that is that when we think about equity-like returns over 100 years, the ASX 200's annualised 7.5-8% per annum.

On a look-forward basis, given the market returns, just shy 30% last financial year, we see it very unlikely that you're going to be realising those returns again any time soon. In fact, there's a much greater risk towards the downside than the upside now, in our opinion.

So then how do you think about still generating 8-10% returns on that?

We're talking about half the risk of the market, and we believe, at the moment, from a portfolio, I guess, alignment and composition perspective, generating 8-10% per annum, whilst taking about half the volatility of the market, can still set portfolios up to generate a great return.

How do we do that? I mean, one of the examples we could probably share with the audience is our exposure to long-short equity funds, the four different strategies we have in the portfolio at the moment, all quite different in that, in their own right.

I think, unfairly, long-short managers always get bunched as a whole, but we've got four different mandates in the portfolio at the moment. Maybe it's worth just talking about the correlation they hold with the market, and how we position them.

MH:

Yeah, I think, one of the things that we're very conscious of is that grouping that long-short managers can get, and be classed as hedge funds.

In fact, we pick the long-short managers that we have, because of what they do – the strategies that they employ. One of them is quite well known for its Fads, Frauds and Failures theme, which we are very supportive of, because it's quite unique, and the way that they approach that is also very unique. And they've got some very impressive screening techniques and processes.

Another one of the long-short strategies that we have is very unique, in that it focuses on consumer discretionary, as well as healthcare. That's again, unique – to have those two different asset classes or segments of the market managed by the same portfolio manager.

But they've brought to that a skill set that is different. In addition, they manage their risk very stringently. The way that they manage their risk is by not only, how they would put their shorts on, or their longs or the types of shares that they're prepared to own, all the things they want to pursue, but they also always have a risk protection strategy in place.

One of the analogies that we've used, it's like you go out and buy yourself a $100,000 car. You wouldn't drive that around uninsured, not only because of the damage you could do to the car, and the cost of repair, but also the cost of the damage you could do to other people.

But these funds would typically spend up to 2% of their portfolio on making sure that they've got that protection in place. The times that we've seen that really come to the fore has been when it's needed to do it.

An example of that would be for three of those funds through the February/March period last year, which you might want to elaborate on.

AM:

Yeah, sure. Nick Griffin's very well known to Livewire, from Munro, last year, we saw their global growth fund. Nick played that theme very well, moving into March last year, he had protection in the fund.

What that means is that yes, his equities that he owned obviously fell with the market drawdown last year. But this protection that he had within the fund, you mentioned before, some manager will have a 2% allocation, and just for our audience's benefit, that 2% allocation, when markets do collapse, that 2% can actually go up multiple times. So suddenly, a 2% weight in the portfolio insurance can actually turn into 8-10% in a very short period of time, as volatility spikes.

So it's buying insurance against an asset, just as the world is familiar with doing, and investors are familiar with doing.

But quite often, when we think about traditionally investing, we just think about buying an asset and going up, not actually protecting that asset in case there is a crash, particularly when it comes to share market investing.

MH:

One thing that investors are often guilty of is looking back and making decisions based on what's happened. We think that looking forward is probably more important than looking back. What things are we looking at at the moment, or asking investors to consider?

AM:

Yeah, well, I think when equity markets have returned 30% for 2020-21, looking forward, now more than ever is incredibly important. And look, just to put some statistics around that. We've been in a 12-year bull market since 2009, and I know some people argue against that and say, "Well, what about last year?"

Yes, last year, we had a pandemic, but we had governments step in within days and weeks, and ensure that that bull market continued by pumping the system with stimulus. If governments hadn't intervened, you imagine how long we'd still be in that sort of prolonged recovery from COVID.

And it's a responsibility of governments to do that when you do have an event that comes out of left field, that you can argue that it wasn't irresponsible Wall Street bakers this time, it was literally a global pandemic, that there has to be a response by governments around the world. And we saw that.

However, that has stimulated markets to return, as I said, 30% last financial year, and we're back at record highs at the moment. It is now more important than ever for investors to be taking stock and then thinking, "Well, where to from here?"

Unfortunately, we've all been guilty before of saying, "Well, I bought Commonwealth Bank 10 years ago or 12 years ago at $25. Now it's at $100, I've done fantastically well. So now, if I have another liquidity event, I'm just going to go on repeat and buy Commonwealth Bank at $100 today."

And who knows? CBA may do very well over the next three to five years. But I think now, more than ever, there is a strong argument to say, "Well, with the US market at 21 times P/E at the moment, are equities the right place to go with portfolios?"

Now, just look at the greats of the investment world at the moment, your Buffetts and your Dalios out there, they've been sitting in cash, they've underperformed the market significantly over the last 12 months because they're taking stock. Because they're not going to play this game or herd mentality where they get sucked into the market, just because that's where the flow of cash is going at the moment.

We actually saw last week that the US Federal Reserve was starting to sell some of their equity exposure in the market. Because last year, for the first time, in a long time, they actually bought the market, as a way of showing stimulus measures.

From a look forward perspective and portfolio positioning, we are light on equities at the moment. We are light on long-only equities. Where we're looking at portfolios at the moment in the market is positioning them from the perspective of having a much lower correlation than where we've been historically, in order to protect the downside, but also still be able to make meaningful returns over the medium term.

MH:

That would also be staying out of, when you talk about equities, you're talking about domestic equities, international equities, small-cap, large-cap, even listed property equities, which are, coincidentally, four of the strongest performing asset classes in the last financial year, all of them up over 30%, I think.

AM:

Yeah, I think you were mentioning to me earlier, that this is, it's a Morningstar table. This is the first time, for a long time, that you've had those four separate asset classes have all returned over 30% in the last 12 months. And I guess I ask you, is there a chance of that repeating?

The answer to that is highly unlikely. But there's, even more, a chance now of a downturn in those markets, as a result of that significant outperformance across the board?

MH:

Yeah. that's one of the key things, I think, about continuing to look forward, rather than back is, you never know what the catalyst is going to be to cause people to decide today's the day they don't want to own whatever assets that they get out of.

Those catalysts have been things like a pandemic. It's back to the Asian debt crisis through to the tech wreck, through to the GFC, as you were referring to earlier, misbehaving bankers, et cetera.

You don't know when people are going to wake up and decide that. So you have to have your own view of the world and be disciplined about how you allocate to those assets because that's where you're going to get the long term growth from.

AM:

Yeah, and everybody's been caught up in the noise at the moment, right? That's where you do have to be disciplined as an investor. Again, just from a look-forward basis, now is more important than ever to be taking stock with one's investment portfolios.

For those out there that did get directional last year, and overweight portfolios towards equities have done really well. The last thing you want, as you've accumulated that wealth post-pandemic, is to lose a substantial amount of it because greed overtakes sensible disciplined behaviour.

MH:

Maybe gold was a good example of that. Or gold companies was a good example of that, through the middle sector of last year, into the end of last year, where I think there was a lot of press around gold company owning millionaires getting printed overnight, off the back of gold price and rerated gold stocks, et cetera.

Now gold's back down, gold stocks, in particular, are down to where they were a year ago, so it can come and go. You've got to stay true to why you're in something, as opposed to trying to jump on the bus.

AM:

Probably the greatest example of that in the last two years has obviously been our friend crypto currency. We took a view on digital assets in February/March last year – not 2021, 2020 – before anyone was actually talking about the space.

What we realise is it's a space that we don't necessarily believe in the underlying fundamentals. But what we realised in February/March last year is that the institutional market was no longer ignoring the digital assets and crypto space, and then blockchain technology.

Again, we spent our time and did the work required to actually identify who we felt in Australia was best to manage that position. We selected Apollo Capital, just down the road from our office here in Cremorne and Richmond, and they've done a stellar job for our investors.

I guess what we saw, moving into the start of this year – when Elon Musk was talking about dog faces on coins, and that's gold, and that's worth $65 billion – this is hubris behaviour in the market, and it's euphoric. As a result of that, we've done very well for investors within that space.

We've continued to support in that space, albeit now, or through a different strategy within digital assets, but it's again being mindful that yes, that asset class, even the last couple of months, has continued to strengthen again.

But it's not being greedy. It's taking money off the table, particularly when you've had that sort of outperformance of four to five times in a very short period.

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