Refocusing on risk in portfolio management

Working on the premise that the world has never been in better shape, yet it never felt worse, investment managers for RBC said there are still investment opportunities in both the equity and credit market irrespective of what happens at the macro level.

While many people are waiting for a post credit crisis era, Kevin Flanagan, head of global manager research at RBC Global Asset Management, believes that what we have seen for the past couple of years in terms of extreme volatility, global contagion, higher correlations and reduced liquidity will persist for the next several years. Therefore, instead of just chasing returns, a lot more emphasis must be placed on these issues evolving around risk, he advised at RBC Wealth Management’s speaker series in November.

Investors should think carefully before making any changes to their portfolio even though the incentive to do so is high in this time of volatility.

“You have to remember whenever you do something you are starting from a new position again,” Flanagan said. Why are you making a change and what is your position then going to look like are important questions to ask and to be taken into account together with risk capacity and budget. Is it really addressing what your needs and objectives are? he asked.

Investors need to have a plan for how they are going to get to where you want to be. “Look at how you are building a portfolio and how much risk you are assuming, know where that risk actually is and be aware of it. Have some sort of contingency plan,” Flanagan said.

It never felt worse

Mark Tiffin of Capital International Asset Management characterised the current market environment saying “the world has never been in better shape, yet it never felt worse”.

In developed countries 1 billion people have an exceptionally high lifestyle, but their world is becoming a maintenance society which is still growing but not as fast as these countries have been accustomed to, he said.

Meanwhile the wealth generated by the Ozzie and Harriet generation gave entitlements to the baby boomer generation that now the grandchildren will have to pay for, he said, including overly generous pension schemes that did not take into account increased longevity.

“Squaring the books is going to be really uncomfortable and disconcerting. It typically takes between five and seven years to work through a credit crisis and pay off the debt. It is very painful, it is very stressful and very disorienting.”

In the developing world on the other hand there is extraordinary growth and an emerging middle class, as China is returning to the leading role it had several centuries ago.

Market immune stocks

According to Tiffin, the main equity strategy in a world that has never been in better shape but never felt worse is to look for companies that are doing well regardless of what is going on at the macro level, in particular IT, consumer and healthcare stocks.

Most of these companies have in common that they can tap into the market of the growing emerging market middle classes and this market offers many opportunities simply due to its sheer size. China added more internet users in the last three years than the US has overall, said Tiffin, and India is adding 10 million mobile phones a month.

“There are a lot of good well managed companies, with free cash flow that are benefitting from billions of people becoming middle class consumers.”

But not all successful companies in this environment have to be in cutting edge technology. Consumer stocks of long established companies such as Nestle with growth coming from emerging market demand for products as diverse as coffee, food and washing powder will also be successful.

In addition certain healthcare companies will be able to show stable returns irrespective of the global economic environment. Diabetes for instance is a huge issue in the developing world, he said, which offers the makers of insulin a growing market.

Lack of confidence

Max Schmid, director of sales at BlueBay Asset Management agreed that the developed world is suffering from its indulgence in debt over the last 20 years and that the process of deleveraging will continue.

“We are probably at a phase in terms of our economic development that feels like the late 70s, early 80s. The only saving grace compared to those times is that we have no inflationary pressures at the moment, despite the huge influx of capital that we had over the past years,” he said.

Schmid believes the mood in the markets is driven by fear rather than the fundamentals, citing the example of Italy, as potentially the catalyst for the biggest crisis in Europe.

“Italy itself is actually not in such a bad position, because Italy’s fiscal position over the last 20 years has not really changed an awful lot. They still have the same debt to GDP ratio that they had 20 years ago. What they have not had in 20 years is growth. And that is mainly down to the wrong policies or failed policies. I think we are living in an environment at the moment where the market place is actually trying to tell the policymakers: wake up, do something.”

The current turmoil is an expression of the lack of confidence the market has in policymakers. In terms of fundamentals, Schmid pointed to Italy’s S9 trillion in private wealth, almost $4 trillion of which is in financial assets, and Italy’s high savings ratio with almost 60 per cent of all outstanding Italian debt owned by Italian investors.

“So Italy is not really the issue in Europe,” Schmid concluded. “The issue is the inability of policymakers to come up with a solution that is acceptable to the market place, investors as well as the general population.”

But policy makers will come to together and the ECB will be forced reluctantly to change its mandate and to start acting as a lender of last resort, because the consequences of the Euro breaking apart are simply too severe, he argued.

Yet for investors the huge volatility in the credit and fixed income market is clouding the outlook for the medium term and is making investments increasingly difficult, even if one has the ability to defend positions by using derivatives, credit default swaps and other forms of hedging techniques.

“This is something that 15 and 20 years ago we did not have and it is also a consequence of the massive injections of liquidity that we had over the last three or four years that is sloshing around the system looking for a home. And literally they are all chasing the same opportunities and the opportunities are getting fewer and fewer these days,” Schmid said.

Overall credit is not a bad place, even if things look a bit gloomy, Schmid said. Corporates in particular are in rude health at the moment and unlike the banks have been able to delever their balance sheets, to refinance and too accumulate cash reserves, which are at historical highs.

There are pockets where you can get high growth but generally the markets are reversing back to the long term mean somewhere in the high single digits, he believes. Double digit return can only be achieved in less liquid strategies and would mean that the investment has to be tied up for two to five years.

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