Investors are wildly more optimistic than financial professionals

Investors are wildly more optimistic than financial professionals

The average investor across the world has wildly more optimistic return expectations than the average financial adviser.

Boston-based Natixis Investment Managers conducted its eighth annual survey of investors, spread across 24 countries over March and April, and found the average expected long term return among the 8,550 respondents was 14.5 per cent per year. In a striking contrast, the global average amongst the financial professionals they surveyed was only 5.3 per cent per year. For the record, Australian investors expected a return of 14.4 per cent, compared to 6 per cent for the financial professionals.

The difference between investor expectations and those of financial professionals is something Natixis calls the ‘expectation gap’. For 2021 it is 174 per cent, but tellingly, it has jumped by almost half from the 2020 gap, after investors’ return expectations leaped by 25 per cent but financial professionals’ were unchanged.

Conspicuously, as financial markets have continued to rise since the surveys started in 2014, investors’ expectations have gone up hand in hand. In 2014, real returns, that is, after inflation, were expected to be 8.9 per cent, and for 2021 it’s 13 per cent.

The branch of economics that studies human behaviour refers to ‘recency bias’, which is where peoples’ expectations, and not just about financial returns, are heavily influenced by their most recent experiences, whether they be good or bad.

It’s easy to theorise that after seeing share markets rebound spectacularly from the fastest ever 30 per cent sell off, to the second fastest ever 100 per cent gain in the US, that it’s recency bias more than common sense that’s leading investors to expect the good times to keep on rolling.

By contrast, financial advisers keep getting told by highly rated, and highly paid, investment consultants, that successive years of strong, above average market returns will almost inevitably be followed by years of below average returns due to the inexorable force of mean reversion. Trees don’t grow to the sky, after all.

According to Vanguard, over the past 50 years Australian shares have averaged a return of 9.7 per cent per year and for international shares it was 9.9 per cent. However, if we change the horizon to 20 years, the return for Australian shares was 8.4 per cent, and for international it was a far less impressive 4.7 per cent. In other words, the point at which you invest makes an enormous difference.

It’s an argument that makes sense and is backed up by compelling data: the likelihood of strong future share market returns declines the higher are valuation multiples. With global share markets hitting new all-time highs, the noise around valuations grows by the day. The challenge for a smart investor is, of course, which valuation multiple do you use and why?

One of the most commonly used multiples is the Cyclically Adjusted Price to Earnings (CAPE) ratio, which is the brainchild of Nobel economics laureate Bob Shiller. For the US it’s currently above 38, and the only time it’s been higher was in the period leading up to the dotcom bust. Australia’s is a far more modest 24.

Advocates of the CAPE ratio point to its ability to predict future share market returns over the next 10 years, based entirely on what’s happened in the past. For the US, at current levels, it’s about 1 per cent per year, and for Australia, it’s about 9 per cent.

However, critics of the CAPE ratio point out it’s all but useless as a timing tool, given the US has been above its long-term average now for almost the whole of this century. Also, critically, trying to compare today’s macro environment, characterised by record low interest rates and bond yields, super accommodative monetary policy and record fiscal stimulus, to past periods that were almost the opposite, is like comparing the proverbial apples and oranges.

The same argument applies to comparing a normal PE ratio to historical averages: how do you account for vastly different inflation, bond yields and policy settings?

Unfortunately, there is no crystal ball that will tell you accurately and consistently what future returns will be. Investors may end up being right for the wrong reasons, or the conservatism of the average financial professional could prove prescient.

Are cryptocurrencies an investable asset?

Are cryptocurrencies an investable asset?

In a year full of remarkable financial events, there are few issues as remarkable, and divisive, as cryptocurrencies. After peaking in April this year at a collective market capitalisation of almost US$2.5 trillion, or about 1 per cent of the world’s investable assets, global cryptocurrencies have dropped 40 per cent, to about US$1.5 trillion. Bitcoin, which accounts for almost half that total, has fallen 45 per cent from its recent highs, but that’s after rising nine-fold in the 12 months before.

It is perhaps that volatility that inspires such strong feelings among those who see cryptocurrencies as a new and legitimate asset class and those who see it as not much more than thin air with a price tag. Berkshire Hathaway Vice Chairman, Charlie Munger, described bitcoin as “disgusting and contrary to the interests of civilization”, while fellow investing legend, Stanley Druckenmiller, bought some last year.

Recently Finance Services Minister, Jane Hume, proclaimed, “I would like to make something clear: cryptocurrency is not a fad. It is an asset class that will grow in importance.” That brought critics of the unregulated crypto marketing industry out swinging, pointing out there are currently more than 5,000 cryptocurrencies in circulation and a new one can be created in 15 minutes. Of itself, that is really no different to being able to list a new mining exploration company in a few weeks; the timeline is different, but the speculative element is identical.

Whether cryptocurrencies are an investable asset class and whether they belong in a portfolio are two very different questions. The usual criticism of crypto as an asset class is that it’s impossible to value because there are no earnings or dividends to model, but gold and other commodities are no different. Dan Morehead, co-CIO of US crypto fund manager Pantera Capital, points out no fiat currency can be valued either, yet relative values are determined through trading every day.

Morehead’s take on crypto is interesting. While he concedes probably the bulk of bitcoin investors are simply speculators and much of the balance are libertarians convinced of the debasement of fiat currencies, he argues it has definite utility that is steadily becoming more apparent. He sees the internet as having revolutionised countless major industries worldwide, but finance has yet to be fully disrupted. Bitcoin is simply another internet protocol for moving data around, providing the means to send money anywhere in the world instantly and for no cost. After only 10 years it’s still very early days for bitcoin, which exacerbates volatility, but as the number of users increases, he expects that volatility to settle.

Pantera has analysed the growth of bitcoin’s price and user base since its inception in the GFC and concluded there has been a remarkable consistency: both have increased, in lockstep, by five orders of magnitude since 2010, (there was one point where they diverged due to price volatility, but they caught up again 15 months later).

It works out at a US$200 increase for every million new users (exactly how they calculate ‘new users’ is unclear). Based on that, they have calculated a long-term trend, which has proven impressively accurate, albeit with that sometimes gut-wrenching volatility.

Are cryptocurrencies an investable asset chart

In an exercise that is either astonishing or one hell of a fluke, on 15 April 2020, when bitcoin was trading at US$8,988, Pantera used its mathematical model to forecast the bitcoin price month by month out to August 2021. The 12-month forecast, for 15 April 2021, was US$62,968, which required an increase of 601 per cent. The actual price ended up at US63,237, a variance of only 0.4 per cent. Then that volatility struck again, sending the May price 37 per cent below the forecast.

Morehead remains convinced the price will, once again, catch up. He argues investing 1 per cent of your portfolio in cryptocurrencies means you’re in the game if they eventually account for 5 per cent of global investable assets, and if they go to zero, it shouldn’t have hurt too much.

Asset allocation consultant, Tim Farrelly, says that since bitcoin is investable, it qualifies as an asset class. However, until he’s convinced you can get a meaningful forecast for its price and relationship to other assets, there’s no chance it will be included in his portfolios. “Do I see it like gold? I’m prepared to give a nod to 2,000 years of history that gold isn’t going away. I’m not so sure bitcoin will stack up in the same way. I wouldn’t be surprised if in 10 years’ time everyone says ‘what were we thinking?’”

How a hedge can counter currency fluctuations in your portfolio

How a hedge can counter currency fluctuations in your portfolio

In the darkest hours of the 2020 Virus Crisis the Australian dollar collapsed to 55 cents against the US dollar as the Little Aussie Battler was dumped in the rush to secure the safety of the default global currency. Once the panic was over, the Australian dollar began a revaluation journey that has seen it rise back to 78 cents.

Over that same period of revaluation, overseas share markets also staged a spectacular recovery, led by the US, but many Australian investors were left wondering why the returns from their international shares failed to keep up. The answer lies in what is referred to as ‘the currency effect’ due to the rising Australian dollar (AUD).

There’s no question the diversification offered by investing in international assets provides enormous benefits to a portfolio, as well as opportunities that are simply not available in the Australian market. However, on top of the challenge of finding attractive investments, there’s the added obstacle that fluctuations in the currency can have a sizeable impact on returns.

Just like shares, a currency can be cheap or expensive. When the Australian dollar is cheap, it takes more to buy the equivalent amount of a foreign currency, and vice versa. It’s a matter for debate as to what level the AUD needs to fall to in order to be considered ‘cheap’, but over the past 20 years anywhere below 65 cents is a decent rule of thumb, and around 88 it’s getting expensive.

The problem comes when cheap Australian dollars are used to buy an international asset and then the dollar rises strongly, as happened last year.

For instance, buying US$20,000 worth of a US stock when the AUD is at 65 cents, will cost A$30,769 (20,000/0.65). If the share price rises by 10 percent over the next year and the currency remains unchanged, the investment will be worth A$33,846 (22,000/0.65).

However, if instead the AUD had appreciated by 20 per cent, to 78 cents, the investment would only be worth A$28,205 (22,000/0.78). The currency effect has more than wiped out the benefits of the higher share price.

The way to overcome this potential problem is to ‘hedge’ the currency, which eliminates the impact of currency fluctuations. A hedge acts like a form of insurance, so the return will only reflect the change in value of the underlying investment.

To illustrate with an example, VanEck has an ETF listed in Australia that is based on the MSCI World Quality Index (‘quality’ is a filter that targets higher growth), which comes in a hedged and unhedged version.

Between the bottoming of global share markets in March 2020 to the end of April this year, the hedged version, QHAL, went up by more than 73 per cent. The unhedged version of the exact same portfolio went up by only 32 per cent. The difference was entirely due to the impact of the rising Australian dollar.

The impact of currency fluctuations on your portfolio graph

Indeed, any Australian-bought, unhedged international investment will have underperformed a hedged version by the same amount over that same period. The opposite can happen too. In 2011, taking advantage of the AUD trading at US$1.10 to buy unhedged international investments,  provided a multi-year tailwind as the currency gradually fell back toward its long-term trading range.

There are three solutions to address the currency effect on a portfolio. First, if the AUD appears cheap, it is possible to buy some international investments in a hedged version.

Second, there are ETFs that can act as a kind of insurance overlay for a whole portfolio. For example, the BetaShares Strong Australian Dollar Fund (AUDS) is designed to increase by more than 2 per cent if the Australian dollar rises against the US dollar by 1 per cent. Their Strong US Dollar Fund does the opposite.

Third, do nothing. There is research that argues the long-term effects of currency fluctuations are negligible because it tends to gyrate around the average. So those times the Aussie dollar appears cheap simply offset those that it appears expensive

Listed property trusts: primed for a rebound

Listed property trusts: primed for a rebound

Property was possibly the worst affected sector when governments around the world pulled the plug on their economies in 2020. Not only did workers stop going into office buildings and shoppers stopped going to malls, but landlords were forced to shoulder the added burden of rent holidays and eviction moratoriums.

Little wonder real estate indices plunged. Locally the Australian Real Estate Investment Trust (AREIT) index fell 39% between the end of January and March last year, while the global benchmark, the FTSE EPRA Nareit Global index (GREIT), dropped 28% (in USD terms).

However, lingering concerns about both delays in returning to work combined with the effect the new paradigm of working from home will have on valuations for commercial property, as well as the impact of the accelerated migration to online shopping on retail values, have seen real estate indices lagging behind the broader share markets’ recoveries following the COVID crash.

The AREITs index is still 14% below its high of last year, while the ASX200 is only 1% away. Likewise, GREITs have managed to get square with last year’s high, but they’re a long way behind the 19% increase in global shares.

These differences offer smart investors the opportunity to buy what some strategists are describing as the only cheap sector left. Tim Farrelly, a highly regarded asset allocation consultant, recently wrote “Despite pretty severe assumptions on the outlook for rental growth, such as a fall in real office rents of 45% and a fall in real retail rents of 20% over the next decade, the overall impact on 10-year returns is not nearly as catastrophic as might be expected, as markets appear to have priced in these falls and more.”

Indeed, Farrelly’s 10-year return forecast for AREITs is 6.8% per year at current levels, while the forecast for Australian shares is 4.8%. Likewise, Heuristic Investment Systems, another asset allocation consultant, has a 10-year forecast return of 6.25% and an overweight recommendation.

While AREITs do offer compelling long-term value at current levels, our domestic market does suffer some limitations. It is highly concentrated, with the top 10 companies accounting for more than 80% of the ASX 300 AREIT index, and just three sectors, retail, industrial and office, making up more than 60%. The superstar of Australian property trusts, Goodman Group, alone is almost one quarter of the whole index.

By contrast, global REITs not only offer the compelling value, plus, at more than A$2.4 trillion, the total market is more than 19 times bigger than Australia’s. The top 10 companies account for less than 25% of the index and the biggest single company is only 5%.

Most importantly, there is abundant diversification, including to sectors that offer leverage to some of the most important structural themes in global markets. If you want to gain exposure to growing digitisation, 3% of the index is data centres; or e-commerce, 12%  is industrial; for demographics, healthcare is 7%, and for urbanisation, 18% is residential.

According to Vanguard, global property was the best returning asset class in the 20 years to 2020, with an annual return of 8.5%. Resolution Capital, an Australian GREIT manager, also points out the asset class enjoyed lower earnings volatility than global equities.

Despite that history of strong returns, 2020 was its worst year since the GFC at -17%. By contrast, however, this time the fall was not because of excessive debt or weak balance sheets, it was a classic exogenous shock. With the progressive relaxation of government restrictions, conditions are in place for a strong rebound.

An added attraction is that historically REITs have been a terrific hedge against inflation, since both rents and property values are typically tied to it. This may sound counterintuitive if you’ve come across the popular misconception that REIT valuations are inversely affected by bond yields, that is, when yields rise, values fall.

Chris Bedingfield, co-portfolio manager of the Quay Global Real Estate Fund, points out that, “Over the long-term, there is actually no correlation at all between REIT valuations and bond yields. However, over the short-term, it seems there are enough investors who believe it that it becomes a self-fulfilling prophecy.” Notably, over the March quarter, GREITs returned more than 7% despite bond yields rising sharply.

To gain exposure to GREITs, you can buy an index fund, such as the VanEck Vectors FTSE International Property ETF (REIT.ASX), or, if you’re wary about the potential for COVID risks, you can choose an actively managed fund from the likes of Quay Global Investors or Resolution Capital.

Still time to get on board for value stocks

Still time to get on board for value stocks

September 2020 marked what could be one of the most significant changes in the stock market for the past 12 years: value stocks started to outperform growth stocks. Importantly, this rotation could go on for a long time to come, offering opportunities for substantial gains.

What is meant by ‘growth’ and ‘value’ stocks?

Growth companies are those whose earnings can grow independently of the broader economy, the classic example being tech companies, or some health care stocks. Value companies are those whose earnings go up and down with the economic cycle, thus they are also called ‘cyclical’ stocks.

Since the GFC ended, value stocks have underperformed growth by the greatest margin ever. Why did that happen?

Cyclical stocks are dependent on what you might call ‘organic’ GDP growth. On one side of the economy, the GFC caused a massive slowdown in private sector growth as companies tried to get their balance sheets back in order by reducing borrowing, and on the other side, governments all over the world tried to reduce their spending to avoid blowing out national debt levels, a policy also known as austerity.

The consequence was the post-GFC economic recovery was the slowest and weakest on record, so it followed that cyclical companies’ earnings growth was also weak. Naturally, investors backed growth companies instead.

Why are value stocks back in favour?

Governments around the world have responded to the COVID crisis with massive amounts of fiscal support, which has ignited organic economic growth. Here in Australia the federal government has injected the equivalent of 13 per cent of GDP in brand new money, plus another 2 per cent came from early superannuation withdrawals. In the US it’s been a mind boggling 25 per cent, and even Europe has joined in.

The upshot is, after most economies reported record falls in GDP in June of last year, we’ve seen a sharp reversal. Australia recorded back to back quarterly GDP growth above 3 per cent for the first time in the 60 year history of the National Accounts. And in the US, Goldman Sachs is forecasting 2021 will see 8 per cent growth for the first time in 70 years.

As usual, the share market has anticipated the reversal of economic fortunes and value stocks have already enjoyed a sizeable rally. From its bottom last year, the Australian bank sector has bounced 39 per cent, energy by 34 per cent (after oil famously traded below zero last year) and materials 17 per cent.

Why value stocks could rally for a while yet

While they are sizeable moves already, it’s possible the rotation toward value stocks will continue for some time yet. The sheer size of the government stimulus packages saw the Australian household savings rate peak at 20 per cent, and it’s still at 12 per cent, which represents a lot of potential spending still to come. In the US, households are estimated to be sitting on more than US$1.6 trillion in savings, or about 9 per cent of GDP.

Another reason is shown in the chart. In the 12 years since the GFC global value stocks gave up almost 30 years of outperformance against growth stocks and appear to have only just started to claw some of that back. There have been other attempts to turn the tide that were short lived, but none have been backed by such a compelling change in macro support. Indeed, Richard Bernstein of Bernstein Advisors, formerly the Chief Investment Strategist at Merrill Lynch and one of only 57 inductees to Institutional Investor magazine’s Hall of Fame, said “the difference in performance (between value and growth stocks) could be startling to investors over the next couple of years”.

Still time to get on board for value stocks graph

How to position your portfolio

There are plenty of value-oriented fund managers you can invest with, like Perpetual and Platinum. I’ve also written previously that I think the resources sector faces a strong outlook. There are unlisted managed funds that specialise in that area, like Ausbil’s Global Resources Fund, or a listed one is the Tribeca Global Natural Resources LIC (TGF.ASX). BetaShares has an Australian resources ETF, but 53 per cent is invested in BHP, RIO and Fortescue, so it’s heavily influenced by the iron ore price.

For global exposure, VanEck’s new VLUE ETF uses a proprietary ‘Value Enhanced’ algorithm to invest in a basket of 250 value stocks from across the developed markets ex-Australia. And finally, Europe, the UK and Japan also offer a value-oriented bias.

Call us today if you’d like to discuss how to gain exposure to value stocks in your portfolio.