The bubble in everything (and how to manage it)

Jerome Lander


There is (arguably of course) a bubble in nearly every mainstream asset class.  A bubble in debt markets, a bubble in property, a bubble in equity, a bubble in private assets, and a bubble in the way portfolios are managed.  This is an artificially created result of easy monetary and fiscal policies that have been employed by global governments for many years now in an effort to boost asset prices (successfully).  These policies appear unsustainable in the long term.  If something can’t be sustained, then eventually it won’t be…

 Bubbles can get bigger, subside slowly or burst. Portfolios need to be prepared for any of these to happen, yet most appear woefully prepared for anything but the best-case scenario – that the bubbles continue getting bigger from here by continuing easy monetary and fiscal policies and nothing else substantial going wrong! 

 Unfortunately, we are probably already in a long overdue equity and credit bear market in the US – and if not - there is a large probability of it not being that far away (within a year or two).  We are almost certainly in a bear market in Sydney and Melbourne residential real estate!  We define a bear market simply as one which is more likely to lose you money (in real terms) than make it. 

 In any case, many markets are priced to deliver very low long-term returns from here.  This is highly relevant as most of what you read is only interested in what will happen in the next few weeks, and operates under the mistaken belief that you will be able to sell out in time – funnily enough, they usually don’t ever sell!  Yet what really matters now for prudent long-term portfolio management is what will happen in the next few years and aligning this with what clients want and need.  Most people want absolute returns with low risk of large losses.  Unfortunately, equity markets have a meaningful risk of very large losses today and hence the weighting to most long only equity strategies should be contained if aligning portfolios with clients’ objectives and risk tolerances is truly important…

 Equity market volatility has ratcheted up recently.  The risk of large sell-offs and portfolio wealth destruction is elevated, and it is elevated right now.  Many portfolios simply do not manage their levels of equity risk adequately and will still be running bull market levels of equity risk right through a bear market…

“Many portfolios simply do not manage their levels of equity risk adequately and will still be running bull market levels of equity risk right through a bear market”

If markets are priced for such low returns, and there is a high risk of large losses, why have such large weightings to these markets - as most portfolios do and will continue to do?  Is this really aligned with clients’ needs and preferences – of course not.  This bubble in the way portfolios are managed is the status quo for most investment management in Australia.  For many, even if they become bearish they will reduce their equity weights by a miserly few percent and they are still fully exposed to indices or index-like exposures.  Token asset allocation changes amongst overpriced assets won’t make a meaningful difference to your portfolio or save you from large losses.   Unfortunately, many institutions are too afraid of being wrong versus their peer group, whereas we posit that what one should be concerned about (at least from the point of view of being aligned with clients) is losing client money. 

“There has never been a better time to focus on managing risk well”

 2 Steps to Better Managing Portfolio Risk

1. Identify how much risk you are taking

First, identify how much risk you are taking and whether this is aligned with your goals and appropriate for you.  One easy way to do this will be to assess how much loss your overall portfolio experienced in October.  Losses of greater than 5% in October suggest that your money is probably being managed quite aggressively and has a large degree of equity risk, and hence large risk of future losses.  If this level of loss made you nervous, you may need to de-risk for this reason alone.  

Note that portfolios that include illiquid assets that aren’t valued by the market on a daily basis (e.g private equity, direct real estate and infrastructure) may be understating their risk levels very significantly, as they don’t price their assets to reflect true market pricing and risk.  Hence, portfolios with illiquid assets may be aggressive portfolios even if they experienced portfolio losses of less than 5% in October.  One could adjust for this illiquidity by simply taking the illiquid asset weighting in portfolios and applying the appropriate equity equivalent loss in October to them to estimate a true return (for example, this may be somewhere between 3% for property to 10% for private equity).

2. Consider de-risking, and alternative investment strategies

Most portfolios are relatively passively managed and based on a strategic asset allocation approach with fairly static fixed weightings to mainstream long only investments.  These portfolios are fully exposed to the “bubble in everything” and can be expected to experience low long term returns in future and potentially very large drawdowns i.e. they appear dangerously unattractive!  You will need to do something else if you don’t want a high likelihood of this result.  If you are a fund or adviser you may need to broaden your connections and toolkit to offer your clients a solution which is better aligned with their needs. 

“Most portfolios are relatively passively managed and based on a strategic asset allocation approach with fairly static fixed weightings to mainstream long only investments”

You might like to consider the following:

An outcome orientated multi-asset investment approach 

An outcome orientated multi-asset investment approach, which actively manages money to client goals and is absolute return biased.  This should create much better alignment with what clients want and need.  It also creates a bigger toolkit for the investment manager as they can better manage risk proactively and don’t have to be as exposed to overpriced markets.  The investment manager can also dynamically manage exposures to better diversify portfolios and manage risk.  As a result, the portfolio should be much less likely to suffer devastating drawdowns in a bear market or crisis, and are more likely to be able to take advantage of better market opportunities at a later time.

Increasing use of alternative managers

Increasing your own use of genuine alternative managers such as market neutral funds and absolute return funds and others which are lowly correlated to equities.  Again, these strategies can be much better aligned with what clients actually want and need and are much better suited to a bear market.  Genuine market neutral funds do not depend upon the market going up to make money.  They should have low or no correlation to market direction.  A useful and rudimentary way to screen for whether an alternative manager is a genuine alternative is to consider their performance in October’s live stress test (they probably had a roughly flat return in October, rather than large negative return along with equities). 

Ramping up your defensive asset classes

Increasing your own use of ‘defensive’ asset classes such as cash. Keep in mind though that most defensive asset classes don’t offer the prospect of a sufficient or satisfactory return over time if not part of a dynamic investment approach.

Unsurprisingly at the end of a long bull market, there are relatively few compelling outcome orientated solutions and market neutral alternative funds to choose from.  Fortunately, however, there are some very good ones.  Some is very helpful and so much better than none if you want to minimise losses.  Have you invested in these?

In Conclusion

Making meaningful positive returns used to be relatively simple and easy and come standard.  Unfortunately, a bubble in everything has made most investors very complacent when it comes to considering the large vulnerabilities and underlying levels of market risks.  Making money unequivocally just got a whole lot harder.  You may need to reconsider your approach and your options if you want to improve your chances from here, and minimise the risk of large losses to your client portfolios…There has never been a better time to focus on managing risk well.

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. 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. Its 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.

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Jerome Lander
Chief Investment Officer

Dr Jerome Lander is a highly experienced, proven Portfolio Manager and a specialist in outcome-based and absolute return investing, which is a client centric approach aligned with many peoples' preferences - and one which is well suited to today's...

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