FINDING RELATIVE VALUE OPPORTUNITIES IN REAL RETURN

Michael O'Dea

Michael O’Dea

Head of Multi Asset

Real return strategies offer investors the convenience of an expanded set of investment opportunities within a single fund. In addition, these funds have tremendous scope to adjust the asset allocation, based on the manager’s view of the likely returns and risks of any asset class. However, this ‘go anywhere’ investment flexibility is not the only differentiating characteristic of real return investing. Leading real return funds can also utilise investment strategies such as “relative value” to exploit risk and return imbalances within asset classes. This enables investors to better diversify risk and enhance their return.

The Perpetual Diversified Real Return Fund seeks to own investments that, irrespective of asset class:
  • Align to the Fund’s investment objective of CPI+ 5% p.a.*
  • Have reliable cash flow
  • Offer the least amount of risk, and
  • Are trading at attractive prices.
  • * over rolling 5 year periods, before fees and tax

The team behind the Perpetual Diversified Real Return Fund (the ‘Fund’) follow the same strong valuation discipline underpinning all investment strategies at Perpetual. Managed by Perpetual’s Multi Asset team, the Fund seeks to own investments with reliable cash-flows at attractive prices irrespective of asset class labels, provided they align to the Fund’s investment objective of delivering inflation plus 5% p.a. over rolling 5 year periods (before fees and tax) with the least amount of risk.

This means that the Fund can invest outside of the more traditional asset classes like domestic and global shares, fixed interest, cash and property to include a broader range of investment opportunities – some of which don’t fit neatly within the classification of a single asset class. Equally, if the risks outweigh the potential benefits, any asset class can be removed from the portfolio.

THE ISSUE OF FIXED INCOME IN TRADITIONAL DIVERSIFIED PORTFOLIOS

The following fixed income examples illustrate the key differentiating features of a real return fund being able to remove individual asset classes from their asset allocation and also turn potential portfolio risks into opportunities, in order to diversify and improve risk adjusted returns for investors.

In June 2016, over one quarter of the world’s government bonds were trading at a negative yield. There are three possible explanations why an investor would choose to hold a bond with a negative nominal yield.

First, if the investor intends on holding the bond to maturity, they may conclude that losing a guaranteed small amount of money is a better alternative to potentially losing more money in another asset class, such as equities, over the same time period. In a similar manner, perhaps they believe the negative nominal yield received will be higher than inflation over that period, in other words deflation.

Second, the strategy could be profitable if they don’t intend on holding the bond until maturity. The investor may expect the value of the bonds will continue to rise as yields decline to even more negative nominal rates and therefore they could make a capital gain by selling this investment to someone else at a higher price; otherwise known as the “greater fool” theory.

Third, since government bonds trading at negative yields were such a large part of the index there was “career risk” and “benchmark risk” if these bonds were excluded from the portfolio. Put simply, investors or fund managers investing this way are focussing on relative returns versus a benchmark, rather than producing positive returns over the rate of inflation. This is a crucial differentiator between real return funds and traditional diversified funds. Where the objective of the client is to build and protect wealth, traditional diversified funds (and those who are managing them) that focus on simply delivering relative returns may not be entirely aligned with the main goals of the people investing in them.

RISK MANAGEMENT OF FIXED INCOME IN THE PERPETUAL REAL RETURN FUND

Despite being labelled defensive investments, government bonds lose money when yields increase. There is nothing defensive about losing money. It doesn’t matter what the label on the tin says, bonds, particularly those trading at historical low yields, can and do lose money in rising interest rate environments. For example, a 10 year government bond would be expected to lose approximately 8.5% (price change) when interest rates increase by 1%. Given the poor likely returns if interest rates were to remain low, and the risk of losing money if interest rates were to increase, Perpetual made a common sense decision to remove all negative yielding government bonds in favour of Australian Government bonds which continued to offer a yield higher than the current rate of inflation.

Over the first 9 months of 2016, Australian bond yields continued to fall (meaning prices rose) and reached a historical low of 1.8%, which was below both the Reserve Bank of Australia’s inflation target band and the expected rate of inflation. The opinion of the Perpetual Multi Asset team was that the risk of Australian bond yields rising had increased due to an improving cyclical outlook for Australian economic growth as the drag from mining investment reduced, improving employment data, strong investment in housing and infrastructure, and the recovery of energy prices leading inflation higher globally. Therefore the returns on offer were not compensating for the risks and it was a clear cut decision; we removed the Fund’s exposure to Australian government bonds.

This view proved to be correct as interest rates across the world increased by approximately 1% on improving inflation data (which had started to improve since July 2016), and then accelerated inflation expectations linked to increased infrastructure spending and tax cuts (fiscal easing) by the newly elected Trump administration.

In March this year we added back Australian bonds into the Fund to take advantage of more attractive higher yields and a shift in our economic outlook for Australia.


In June 2016, over one quarter of the world’s government bonds were trading at a negative yield… Given the poor likely returns if interest rates were to remain low, and the risk of losing money if interest rates were to increase, Perpetual made a common sense decision to remove all negative yielding government bonds in favour of Australian Government bonds which continued to offer a yield higher than the current rate of inflation.

The movement back into Australian bonds coincided with a relative value opportunity in global bonds. The European Central Bank (ECB) is persisting with the quantitative easing (QE) programs first introduced in 2015 despite a broader based recovery in economic growth and core inflation moving higher. For now, ECB intervention and political risks relating to key European elections this year has kept interest rates from rising as much as other parts of the world, notably the US. The yields on German 10 year government bonds (German Bunds) have steadily fallen from 2008 to 2016, and are currently offering a mere 0.35% yield. With European political risk currently receding, economic growth in the region appears more robust, the possibility of the ECB gradually tapering its QE program is increasing. In contrast, US 10 year Treasuries are currently trading at yields of 2.4%; this is 2% higher (‘spread’) from those offered in Germany. Looking at the relationship between German and US 10 year government bonds, this spread has seldom been wider.


At the time of writing, in order to allow investors to potentially profit from shifts in the global economic outlook, we have a relative value position in government bonds which makes money if German Bund yields rise more than US Treasuries. Importantly, this is not a directional view on interest rates – returns are unaffected if bond yields globally go up or down by the same amount – it is the relative move between US and German bonds which is important.


We believe the spread between these two governments bonds is likely to narrow over the balance of the year, given the strength of European economic growth and the declining political risk in Europe. In order to allow investors to potentially profit from this view, we have a relative value position in government bonds which makes money if German Bund yields rise more than US Treasuries. Importantly, this is not a directional view on interest rates – returns are unaffected if bond yields globally go up or down by the same amount – it is the relative move between US and German bonds which is important. In addition, risk management of the position is enhanced by both positive carry and, with the spread coming off a 28 year high, what we believe is a reasonable valuation buffer.

APPLICATION TO PORTFOLIO CONSTRUCTION

Referring to our proprietary four quadrant approach to portfolio construction, “relative value” positions such as this fit in the third quadrant – Diversifying Opportunities. Investments in this quadrant are those that we consider for inclusion in the Fund because they have the potential to provide uncorrelated returns and are not linked to the general movement of the overall stock market.

Often these diversifying investment opportunities are those typically overlooked by traditional balanced funds, simply because they may not always fall neatly into a single asset class. This includes relative value trades, such as the US – German yield spread, as well as currency holdings or skill-based sources of return such as market neutral equities. Including positions with these characteristics can have the effect of improving risk adjusted returns.



WHAT DOES THIS MEAN FOR YOU?

The above highlights how we have managed both the risk and opportunities within the fixed income asset class over time. Initially we removed the government bonds which were the least attractive because of negative yields and following that, exited the asset class entirely when our measures of value, cycle and momentum were unfavourable. The final step is exploiting the potential normalisation of the relationship between two different Government Bond markets as the intervention of central banks begin to recede.

So whilst this example is just one of many investments that the Perpetual Diversified Real Return Fund may hold at any one point in time, it demonstrates how breadth of investment ideas and portfolio construction can help to protect and grow the capital of investors on a daily basis. We monitor these opportunities and decisions continually, as a key component of our risk management process to ensure your portfolio is working towards your objectives.

This brochure has been prepared by Perpetual Investment Management Limited (PIML) ABN 18 000 866 535, AFSL 234426. It is general information only and is not intended to provide you with financial advice or take into account your objectives, financial situation or needs. You should consider, with a financial adviser, whether the information is suitable for your circumstances. To the extent permitted by law, no liability is accepted for any loss or damage as a result of any reliance on this information. The product disclosure statement (PDS) for the Perpetual Diversified Real Return Fund, issued by PIML, should be considered before deciding whether to acquire or hold units in the fund. The PDS can be obtained by calling 1800 022 033 or visiting our website www.perpetual.com.au. No company in the Perpetual Group (Perpetual Group means Perpetual Limited ABN 86 000 431 827 and its subsidiaries) guarantees the performance of any fund or the return of an investor’s capital. Past performance is not indicative of future performance.