1 Are return targets realistic in today’s markets? This marketing document is exclusively for use by Professional Clients and Financial Advisers in Continental Europe (as defined in the important information) and Ireland, Qualified Investors in Switzerland and Professional Clients in Dubai, Jersey, Isle of Man, Malta, Cyprus and the UK. This document may also be used by financial intermediaries in the United States as defined in the important information. This document is not for consumer use, please do not redistribute. Are return targets realistic in today’s markets? March 2017 Contents 1. The foundation of absolute return targets 2. Low economic growth and inflation underpins future policy uncertainty 3. Implications for the relationship between equities and bonds 4. Managing risk 5. Our central economic thesis: a minimum hurdle rate for every investment idea 6. Investment ideas: how to achieve our income and return targets as economic conditions change 7. Conclusion Summary In this paper, we are going to focus on the return targets of absolute return funds and explore how these targets remain achievable even as market conditions change. Some recent criticism of absolute return funds has been fuelled by the increasing realisation that nominal economic growth could remain muted for an extended period of time. The consequences of this macroeconomic backdrop are that interest rates could stay low and therefore potential returns from both fixed income and riskier assets could be limited. We believe that if a multi asset fund has the ability to step away from relying on the direction of core asset classes for returns, then its long-term targets are still achievable. The vital component is that there exists genuine flexibility in the underlying process to access different styles of investing, such as relative value and alternative returns sources, such as volatility, in order to achieve a specified long-term return target through market cycles. More specifically, we discuss how absolute return targets like LIBOR plus 5% per annum (or an equivalent reference rate) aim to capture the long- term equity risk premium and how the level of excess returns that equities can generate relative to cash may be under threat as nominal economic growth rates fall. As a consequence, the relationship between equities and bonds could start to change at a far lower bond yield than in the past. Historically, when bond yields have increased above 5% the correlation between equity and bond returns has turned positive. We believe the critical level could now be 3% not 5%. We discuss how multi asset funds can achieve the long-run equity risk premium even if growth rates remain low. In addition, with reference to our own multi asset portfolios, we explore how defending the downside through robust risk management is as important a component as our unconstrained approach to searching for good long-term investment ideas when seeking to achieve a returns target. Georgina Taylor Research Director, Invesco Perpetual Multi Asset Team
Transcript
1 Are return targets realistic in today’s markets?
This marketing document is exclusively for use by Professional Clients and Financial Advisers in Continental Europe (as defined in the important information) and Ireland, Qualified Investors in Switzerland and Professional Clients in Dubai, Jersey, Isle of Man, Malta, Cyprus and the UK. This document may also be used by financial intermediaries in the United States as defined in the important information. This document is not for consumer use, please do not redistribute.
Are return targets realistic in today’s markets?March 2017
Contents
1. The foundation of absolute return targets
2. Low economic growth and inflation underpins future policy uncertainty
3. Implications for the relationship between equities and bonds
4. Managing risk
5. Our central economic thesis: a minimum hurdle rate for every investment idea
6. Investment ideas: how to achieve our income and return targets as economic conditions change
7. Conclusion
Summary
In this paper, we are going to focus on the return targets of absolute return funds and explore how these targets remain achievable even as market conditions change.
Some recent criticism of absolute return funds has been fuelled by the increasing realisation that nominal economic growth could remain muted for an extended period of time. The consequences of this macroeconomic backdrop are that interest rates could stay low and therefore potential returns from both fixed income and riskier assets could be limited.
We believe that if a multi asset fund has the ability to step away from relying on the direction of core asset classes for returns, then its long-term targets are still achievable. The vital component is that there exists genuine flexibility in the underlying process to access different styles of investing, such as relative value and alternative returns sources, such as volatility, in order to achieve a specified long-term return target through market cycles.
More specifically, we discuss how absolute return targets like LIBOR plus 5% per annum (or an equivalent reference rate) aim to capture the long-term equity risk premium and how the level of excess returns that equities can generate relative to cash may be under threat as nominal economic growth rates fall. As a consequence, the relationship between equities and bonds could start to change at a far lower bond yield than in the past.
Historically, when bond yields have increased above 5% the correlation between equity and bond returns has turned positive. We believe the critical level could now be 3% not 5%. We discuss how multi asset funds can achieve the long-run equity risk premium even if growth rates remain low. In addition, with reference to our own multi asset portfolios, we explore how defending the downside through robust risk management is as important a component as our unconstrained approach to searching for good long-term investment ideas when seeking to achieve a returns target.
Georgina TaylorResearch Director, Invesco Perpetual Multi Asset Team
2 Are return targets realistic in today’s markets?
The long-term equity risk premiumThe equity risk premium represents the excess return that investors would expect as a reward for taking the increased risk of holding equities, versus keeping their money in a risk-free asset such as cash. If an investor deems it appropriate to take on more risk, they have to believe that their investment will give them access to superior returns over the long run. Investing in equities gives investors access to long-term economic growth, which should be reflected in the potential returns of the asset class.
The long-term equity risk premium forms the basis of the return targets of many multi asset funds, including those managed by the Multi Asset team of Invesco Perpetual. A product that can deliver long-term, equity-like returns but with lower volatility versus investing solely in equities is an attractive proposition for investors. As noted above, the equity risk premium represents the excess return that investors demand from equities relative to a risk-free asset. However, what is risk-free in this environment? Ten-year government bonds have typically been used to represent risk-free returns in financial modelling, although a more conservative risk-free base from which to calculate the equity risk premium may be a cash rate such as 3-month interest rates.
Our suite of multi asset funds uses 3-month EURIBOR (or an equivalent local reference rate) as part of their return target. The Invesco Global Targeted Returns strategy targets a gross return of 3-month EURIBOR plus 5% per annum over rolling, three-year periods.1
Figure 1 shows that the annualised excess return of global equities, in US dollars, relative to US 3-month interest rates over the past 40 years has been 5.2%, which is very closely aligned to the total return targets of our strategies. The chart uses the total return of the MSCI World index to represent global equities and 3-month Treasury bills as a global proxy for cash. Over the very long run since 1899, the annualised excess total return of UK equities versus
cash has been 5.8% according to the Barclays Equity Gilt Study 2017.
The previous calculation represents the ex-post equity risk premium, in other words, the observed excess return that equities have delivered relative to cash over time. The drawback of this approach is that it is backward looking and, although helpful for building long-term assumptions for financial models, it is not as helpful for assessing whether there is value in the equity market today. An ex-ante measure of the risk premium is more useful when trying to predict the direction of equity markets, as this approach uses current market metrics to calculate the implied excess return that equities are offering relative to cash at any point in time.
Equities offer a dividend yield, which is one part of the total return of an equity investment, and, over the long run, there is an expectation that these dividends will grow in line with long-term economic growth. The total return of equities, again over the very long run, should be the dividend yield plus dividend growth. The equity risk premium can therefore also be calculated by adding the dividend yield to the future expected dividend growth, less the risk-free return (e.g. 3-month interest rates).
Using this approach, the median ex-ante risk premium over the past 30 years has also been 5.2% (see figure 2). We calculated this by taking the 12-month trailing dividend yield for the MSCI World index each quarter, adding ten-year annualised historic US GDP growth as a proxy for expected dividend growth and then subtracting the 3-month US Treasury rate.
These two approaches, ex-ante and ex-post, both support our view that our long-term annualised return target for our multi asset portfolios of around 5% above short term interest rates is in line with the long-run equity risk premium.
The ex-ante approach to calculating the equity risk premium is reliant on the economic cycle. Future dividend growth expectations are typically anchored
1. The foundation of absolute return targets
Figure 1The annualised excess return of global equities relative to cash over time is 5.2%
Global equities relative to US 3-month T-Bills
31 January 1979 = 100
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1/79 1/83 1/87 1/91 1/95 1/99 1/03 1/07 1/11 1/15
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Source: Thomson Reuters Datastream. Data as at 31 January 2017.
3 Are return targets realistic in today’s markets?
around historic economic growth rates. At turning points in the economic cycle, investors become concerned that long-term potential growth rates could fall and therefore equities could struggle to perform. Figure 2 shows how the ex-ante risk premium fluctuates over time.
The risk premium is sensitive to economic fundamentalsThere are three components to calculating the risk premium: the dividend yield, dividend growth and interest rates. All of these fluctuate and can be important for different reasons. The chart in figure 2 suggests that, in 2008, equities became incredibly attractive as the implied equity risk premium rose substantially above the median 5% level. However, this did not occur because dividends and potential growth increased but because interest rates fell significantly and, therefore, the relative valuation case for equities improved.
Interest rates have been low for an extended period of time during the current economic cycle. Despite such accommodative monetary policy, the economic recovery to date has been lacklustre. Figure 3 shows the rate of nominal economic growth experienced through the US economic cycle, over the long run. The median level of growth reflects median annualised quarter-on-quarter nominal US GDP growth at each point of all previous cycles going back to 1960. The current cycle starts in June 2007 and the last data point is December 2016.
While real GDP growth has been disappointing versus history, nominal growth has been very different versus history because inflation has remained so low.
There is understandably little appetite to return to a high inflation environment, however, inflation at or around typical policy targets could provide a healthy nominal backdrop for an economy and in turn for the profitability of the corporate sector. Weak nominal economic growth is a potential constraint on returns going forward because interest rates are likely to remain low and the potential for dividend growth is arguably muted as earnings growth is likely to be constrained.
Figure 2The ex-ante global equity risk premium fluctuates over time
Source: Thomson Reuters Datastream. Data as at 31 December 2016.
This is captured by looking at the rolling returns available from core asset classes, such as equities and bonds, through the cycle. We anchor our own investment horizon and fund return targets around a three-year time horizon and, therefore, figure 4 shows the rolling, three-year real returns of global equities, deflated by US CPI. The chart in figure 4 is anchored around 5% to reflect the view that the cash-linked component of a returns target should account for inflation, which in turn means that, over the long run, a fund is looking to deliver a real return of around 5%.
As an aside, there are often questions regarding whether a ‘cash plus’ target is equivalent to, worse or better than an ‘inflation plus’ target. Figure 5 suggests that, over the long run they should at the very least even out and that a ‘cash plus’ target tends to be higher than an ‘inflation plus’ target in higher inflation environments such as the 1980s and 1990s. The chart shows the three-year annualised, year-on-year return of 3-month Treasuries versus
Figure 3Nominal US economic growth during the current cycle vs previous cycles
• Previous cycles (1960 to 2007)• Current cycle (2007 to December 2016)
7.3%
3.8%
8.6%
4.4%
-3.2%
3.5%
Starting peak Mid-cycle trough End peak
Previous cycles Current cycle
Source: Thomson Reuters Datastream. Data as at 31 December 2016.
4 Are return targets realistic in today’s markets?
the three-year annualised change in US CPI. When policy makers tighten policy, they typically want to keep real interest rates positive (interest rates less inflation), otherwise, policy will remain too accommodative if real interest rates are negative as an economy improves. A ‘cash plus’ approach therefore incorporates real interest rates plus inflation within the cash part of the returns target, rather than simply isolating inflation. For investors who are reliant on growth assets to hedge inflation risk, the chart shows how different targets perform that role.
The three-year (and indeed the ten-year) annualised real return of global equities has been declining towards 5% over the past few years. However, it is interesting that looking back post the 2001
recession, although the downturn was milder versus the global financial crisis, the rolling three-year real returns for global equities took quite a long period of time to move back above the 5% level.
The challenge this time around is that the decline in the level of annualised returns coincides with an economic recovery, rather than during the direct aftermath of an economic downturn. If interest rates stay low versus history because inflation remains relatively subdued and leads to lower nominal growth rates, how does an absolute return fund achieve its cash plus 5% target if long-term equity returns look under pressure and bond yields are already very low?
Figure 4Three-year rolling returns of global equities, deflated by US CPI
3-year annualised real returns: MSCI World Long-term equity risk premium
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3-year annualised real returns: MSCI World
Source: Thomson Reuters Datastream. Data as at 31 December 2016. Total return, US dollar.
Figure 5Cash versus inflation: returns over time
3-year annualised return from 3-month Treasuries 3-year annualised US CPI
3-year annualised return from 3-month Treasuries 3-year annualised US CPI
Source: Thomson Reuters Datastream. Data as at 31 December 2016. Returns are in US dollars.
5 Are return targets realistic in today’s markets?
Figure 6 shows the path of ten-year annualised nominal and real GDP growth in the US and the UK. Ten-year annualised economic growth rates for the US and the UK are now around 3% and real rates of growth are between 1% and 1.5%. Herein lies the dilemma in understanding how long-term investment returns can still be achieved.
The reasons these low economic growth rates persist is a paper in itself. However, there are some areas that are important for discussion in order to understand where potential returns for a multi asset fund can be achieved.
Debt remains an issue. If debt levels remain high, the behaviour of particular sectors across the economy can be distorted for long periods of time. Firstly, income is used to pay down debt rather than buy goods, which puts a cap on economic activity. However, high debt levels can also alter the behaviour of central banks because, if certain parts of the economy are still laden with debt, their sensitivity to interest rates rising is far greater and, therefore, interest rates may need to stay lower for longer. In economies where some sectors remain very well supported (debtors) versus other sectors (savers), this can exaggerate existing distortions. In line with this, US Federal Reserve (Fed) Chair Janet Yellen finally acknowledged that monetary policy has a varying impact on the US household sector as different parts of the sector hold different levels of debt, which means changes in interest rates can have a very different impact. This poses a dilemma for central bank decision making.
“ Prior to the financial crisis, these so-called representative-agent models were the dominant paradigm for analysing many macroeconomic questions. However, a disaggregated approach seems needed to understand some key aspects of the Great Recession.” Janet Yellen, 14 October 2016.
2. Low economic growth and inflation underpin future policy uncertainty
Figure 6Ten-year annualised GDP growth rates in the US and the UK
10-year annualised US real GDP growth 10-year annualised UK real GDP growth 10-year annualised US nominal GDP growth 10-year annualised UK nominal GDP growth
% %
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12/86 12/92 12/98 12/04 12/10 12/16
10-year annualised US real GDP growth10-year annualised US nominal GDP…
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10-year annualised UK real GDP growth
Source: Thomson Reuters Datastream. Data as at 31 December 2016.
Arguably, the European Central Bank (ECB) has the most extreme example of this due to the diverse range of national economies within the euro area and the need to keep policy at a level that supports all of them. The result is that countries such as Germany benefit from having a very competitive currency but countries, such as Italy, which arguably need a weaker exchange rate to remain competitive, continue to struggle.
A lower nominal growth and interest rate environment suggests that the risk premium embedded within core asset classes could possibly be under threat, at least for a period of time. Investors appear to demand around 5% over cash to take on the risk of investing in equity markets, as discussed previously, and alongside this long-term bond yields are typically anchored around a long-term nominal growth rate. That level of yield looks increasingly to be limited to around 3% rather than the historic average level of 5%, which means the potential total return from fixed income assets is also under threat.
However, this is not a new phenomenon. During each cycle, there is typically a period of time when equity and bond returns fall well below their long-run averages. The catalyst for this appears to be policy uncertainty. When policy uncertainty rises, the return on equities typically diminishes – this could be because the long-term growth rate is being threatened by an economic environment that is not improving, or it could be due to the risk of tighter policy, which threatens to choke off growth too quickly.
One simple way to capture this relationship is to take an index that measures policy uncertainty. The Chicago Economic Policy Uncertainty index is a measure of uncertainty based on news coverage about policy-related uncertainty, the number of tax changes that are expected to happen going forward and the dispersion of economic forecasts.
6 Are return targets realistic in today’s markets?
We have been living in exceptional times, particularly for policy, which makes it very complicated to construct a case study entirely relevant for today’s economic environment. However, going back over previous cycles, there are some similarities and figure 7 highlights one.
Following the economic downturns of the early 1990s, early 2000s and the global financial crisis, policy uncertainty increased. In all cases, it was unclear as to the path of policy in response to the slowdown in economic growth. The perception of markets this time around seems to be that this cycle is different and the level of policy uncertainty is unusual. This is true, the chart in figure 7 illustrates that we have had a number of periods since the
Given our discussion on the equity risk premium above, generating LIBOR plus 5% becomes even more challenging if fixed income assets do not deliver enough return to offset low or even negative equity market returns going forward. Investors have enjoyed a number of years where equities and bonds have both delivered attractive returns. The risk is that the relationship between the asset classes starts to change as interest rates potentially edge higher.
Each point on the chart in figure 8 shows the 1-year correlation between US 10-year government bonds and global equities, versus the level of the bond yield on the horizontal axis. There have been a number of periods historically when the correlation between equities and bonds has been positive. This is an issue for asset allocation because if bonds and equities rise, and also fall, together, there will be less diversification within a multi asset portfolio that relies on the performance of the two asset classes
global financial crisis when policy uncertainty has increased: firstly, in response to quantitative easing (QE), secondly, in response to the possibility that the Fed was going to taper QE in 2013 and, more recently, when the Fed started to raise interest rates. However, figure 7 shows that this may not be as unusual as is perceived. In the early 1990s, there were a few periods of policy uncertainty following the official recession, and again after the 2001 economic downturn. In both cases, the annualised returns for equities did not improve until the period of heightened policy uncertainty had passed. The difference this time around is the longevity of this heightened level of policy uncertainty and its ongoing impact on financial markets during the latter part of this economic cycle.
Figure 7Policy Uncertainty Index vs rolling, three-year annualised returns of global equity markets (inverted)
US economic policy uncertainty index 3-year annualised real equity returns, inverted (RHS)
US ECONOMIC POLICY UNCERTAINTY INDEX - NEWS BASEDNADJ
Source: Thomson Reuters Datastream. Data as at 31 December 2016. Global equities represented by MSCI World, total returns, US dollar.
3. Implications for the relationship between equities and bonds
complementing each other through the cycle. Again, this challenges the potential investment return of a portfolio, which relies on returns from these two asset classes.
In the past, when bond yields have risen above 5%, the correlation between bonds and equities has turned positive. The reason for this is that the discount rate used to discount future cash flows has risen towards, or even above, the long-term growth assumption used in a financial modelling approach to calculating the fair value of equity markets. The rise in the discount rate starts to offset a rise in growth expectations and, therefore, the future cash flows for an equity market look less attractive.
The critical level for bond yields is now arguably between 3% and 4% because nominal growth rates have fallen so significantly over the past few years. This is a risk for equity markets given
7 Are return targets realistic in today’s markets?
Figure 8The level of bond yields has mattered for the correlation between equities and bonds
• 1-year correlation of US bonds and equities
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US 10-year bond yield in %
Source: Thomson Reuters Datastream. Period covered: 1 January 1981 to 13 July 2015. Benchmarks: US Benchmark 10 Year Government index used as a proxy for US interest rates and with regard to correlation figures is compared to Datastream Global Equity Index in USD.
Figure 9A similar pattern is visible in the UK
• 1-year correlation of UK bonds and equities
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UK 10-year bond yield in %
Source: Thomson Reuters Datastream. Period covered: 1 January 1981 to 13 July 2015. Benchmarks: UK Benchmark 10 Year Government index used as a proxy for UK interest rates and with regard to correlation figures is compared to Datastream UK Equity Index.
the increase in bond yields that has occurred over the past year.
Given the risk that equities and bonds do not always diversify each other over the long run, a more flexible approach to multi asset investing could be worth considering. In our view, a multi asset fund needs to move beyond an asset allocation framework to take a different approach. A more flexible approach can give investors access to a different return stream, which complements traditional asset class returns, rather than mimicking their behaviour.
This also feeds into an important point about the dual targets of multi asset funds. One element of achieving a return target of 3-month LIBOR plus 5% over the medium term is attempting to avoid major drawdowns in equities and bonds and this is why, typically, these types of funds target risk as well as returns.
Figure 10 shows the correlation of the Invesco Global Targeted Returns Fund with different indices representing equities, bonds, commodities and the US dollar since it was launched on 18 December 2013. The correlation values are relatively low, suggesting the return profile of the strategy is different to that of traditional equity or bond investments.
Figure 11 highlights the performance of the Invesco Global Targeted Returns Fund during the significant drawdowns seen in equities since its inception. Here we can see the benefits of having a diversified return stream, in that our performance has withstood the major sell-offs seen in a single asset class, like equities, and stayed on track for its return target. Such drawdowns can contribute towards keeping real returns for a single asset class below 5% for an extended period of time and demonstrate one of the challenges facing a strategy pursuing a similar target.
Investing in ideas not asset classesOur philosophy is based on investing in ideas. During the first step of our process, we look for good investment ideas, which we believe can generate a positive return over the next two to three years. The second step of the process is to look at the best combination of those return generating ideas. If bond and equity returns look under pressure, we can have some exposure to both asset types in our portfolios but we are not restricted to relying only on their risk premiums to generate returns. We can incorporate other investment ideas, which reflect different styles of investing, in order to help us
Figure 10Correlation analysis of Invesco Global Targeted Returns Fund
Asset class Correlation with the fund
Global stocks 0.32
US stocks 0.27
European stocks 0.42
Emerging markets stocks 0.38
Global government bonds -0.16
Global bonds -0.14
Commodities 0.07
Currency (USD) 0.30
Source: Bloomberg. Period covered: 18 December 2013 (inception date of the fund) through 28 February 2017. Based on weekly returns. Global stocks are represented by the MSCI World Index. US stocks are represented by the S&P 500 index. European stocks are represented by the Eurostoxx® 50 index. Emerging Market stocks are represented by the MSCI Emerging Market index. Global government bonds are represented by the Bloomberg Global Developed Sovereign Bond index. Global bonds are represented by the Barclays Global Aggregate index. Commodities are represented by the Bloomberg Commodity index. Currency is represented by the US Dollar index. An investment cannot be made directly into an index.
8 Are return targets realistic in today’s markets?
achieve positive returns but with lower risk versus investing in equities and/or bonds alone.
Our flexible approach means there are a number of tools that we can employ and here we highlight some of the opportunities available to us, such as
investing in volatility, relative value and other techniques, which can help us target equity-like returns throughout the cycle.
Figure 11Gross performance of the Invesco Global Targeted Returns Fund versus global equities since inception
Invesco Global Targeted Returns Fund MSCI World 100% hedged to euro index
Source: Invesco, Bloomberg. Data period: 18 December 2013 to 28 February 2017. Global equities represented by MSCI World 100% hedged to euro index (total return, in euro). Inception date 18 December 2013. Fund performance figures are shown in euro, inclusive of reinvested income and gross of ongoing charges and portfolio transaction costs. The figures do not reflect the entry charge paid by individual investors. The net performance over the same period for the fund can be found in the appendix on page 15. The performance data shown relates to a past period, which is not a guide to future returns.
Seeking to deliver cash plus 5% per annum throughout the economic cycle also involves managing risk very carefully. As discussed, the correlation between equities and bonds changes over time and, therefore, an asset allocation approach to investing carries inherent risks because equities and bonds can fall at the same time. The basis of our approach is to combine individual investment ideas together into a single, risk-managed portfolio. This means we invest in ideas that we believe have an upward trajectory to their return profile, however, we also include ideas that behave differently, to ensure there is always diversification embedded within a portfolio. This means our portfolios are not hostage to having to achieve a 100% hit rate over time (so not all ideas need to be positive all the time). We base our assumptions on a c. 60% hit rate across a portfolio in order to achieve our return target.
As part of the portfolio construction process, we analyse the correlation between ideas in order to
achieve an outcome of cash plus 5% but with less than half the volatility of global equities. The starting point for this analysis is the output from our risk model seen in figure 12.
This output uses the APT risk model. The left hand side shows that, on an undiversified basis, our individual investment ideas take a similar level of risk to global equities. However, once the model takes into account the correlation between the ideas, we expect to deliver these returns with much lower volatility because of how the individual ideas interact with each other – this is the diversification benefit we gain from combining our ideas. The expected volatility of our combined portfolio is shown on the right hand side of the chart.
As an example, we have two ideas in our portfolios that, at face value, may seem to contradict each other. We are buying Japanese equities but we are also buying the Japanese yen. We believe there are good reasons why both will deliver a positive return
4. Managing risk
9 Are return targets realistic in today’s markets?
Figure 12Invesco Global Targeted Returns Fund: Expected diversification through combining investment ideas
Total independent risk(1)
15.54%Total portfolio risk(2)
5.06%
50% of global equity risk(3)
Div
ersi
ficat
ion
bene
fit
• Ideas expressed through Invesco strategies Credit – US High Yield – Selective Credit Equity – UK – Selective Asia Exposure – Global – European Divergence
• Other investment ideas Volatility – Asian Equities vs US EquitiesInterest Rates – Yield Compression – Sweden – Swap Spreads – Selective EM Debt – Japanese Curve Steepener – European Curve Steepener – Australia vs USInflation – US vs UKEquity – US Large Cap vs Small Cap – Japan – France vs Germany & Italy Currency – US Dollar vs Euro – US Dollar vs Canadian Dollar – Russian Ruble vs Canadian Dollar – Long Sterling – Japanese Yen vs South Korean Won – Indian Rupee vs Chinese Renminbi – Chilean Peso vs Aus and NZ Dollars Commodity – Commodity Carry
Source: Invesco. Data as at 27 February 2017. For illustrative purposes only. There is no guarantee this target will be achieved.(1) Independent risk – the expected volatility of an individual idea as measured by its standard deviation over the last three and a half years. (2) Portfolio risk – the expected volatility of the fund as measured by the standard deviation of the current portfolio of ideas over the last three and a half years. (3) Global equity risk is the expected volatility of the MSCI World index as measured by its standard deviation over the last three and a half years, 12.33% as at 28 February 2017.
over the next few years, however, day to day, they work differently and therefore are a good offset to each other. The chart in figure 13 shows the performance of our Japanese yen versus South Korean won investment idea alongside our Japanese equities idea. Both ideas have delivered a positive return but the correlation of their daily returns is -44%, which suggests a good level of diversification for our portfolios through holding these two ideas at the same time.
Our process is not reliant on one risk model, however, because risk models are hostage to the period of time over which their calculations are based. Therefore, we also carry out extensive scenario testing and stress testing in order to examine the downside risk of the portfolios should a particular scenario play out over time. This extra level of risk analysis, which we incorporate into the investment process, also helps us toward our aim of delivering our return targets, despite a changing economic backdrop through time.
Figure 13Both Japanese ideas have contributed to returns in the Invesco Global Targeted Returns strategy but have been negatively correlated
Performance, in % Correlation
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Japanese Yenvs. South Korean Won
Nikkei Index Correlation,daily returns (RHS)
Since 4th March 2015 Since 4th March 2015
Source: Bloomberg. Period covered 4 March 2015 to 27 February 2017. Returns in GBP.
10 Are return targets realistic in today’s markets?
By carrying out all of the risk analysis discussed above, we try to include ideas in our portfolios that will help if market dynamics change. However, we have to believe that all of our investment ideas will deliver a positive return over time against the economic and market view that is our central view of the world. We do not hold any ideas on a purely defensive basis, as buying protection and holding defensive assets could be a drag on performance over time. We believe that each and every idea must contribute towards achieving our return targets.
We seek to find investment ideas with a return profile which has an upward trajectory, but which complement other ideas in the portfolio to provide diversification on a day-to-day basis.
Therefore, before we discuss the specifics of our investment ideas, it is worth discussing the team’s central economic thesis. As a team, we revise this two- to three-year economic outlook at least once a month and view it as a hurdle for every idea to earn its place in a portfolio. When we launched the Invesco Global Targeted Returns strategy three and
a half years ago, our central economic outlook could have been summarised as ‘cautious optimism’, in which economic growth was lacklustre but we believed policy would remain very accommodative around the world. However, as we have discussed in this paper, the world has changed and we are acutely aware that we are now operating in an extended low growth, low inflation world, with little visibility as to when this part of the economic cycle will come to an end. Policy is tightening in some parts of the world while it remains extremely loose in others and we are entering a phase of the cycle where the fragmentation of global growth, inflation and policy may drive financial markets over the next few years. Our central economic thesis is featured in figure 14 and shows how we acknowledge changes in the economic backdrop. Once changes are reflected here, on review, we must believe that every idea in or being considered for a portfolio can make positive investment returns in this economic environment.
5. Our central economic thesis: a minimum hurdle rate for every investment idea
Figure 14Our central economic thesis
• Challenging global growth may fragment– Structural pressures (e.g. China) will keep economic growth rates subdued– Possible fiscal boost in the US but there are headwinds for growth– Future growth momentum in Europe not helped by political uncertainty
• Policy effectiveness impacted by financial linkages, e.g. US dollar– Official monetary and/or fiscal policy choices are becoming more difficult– Strains in funding markets already imply monetary tightening (e.g. EM)– Lower trend growth and policy rates likely to cap the upside for bond yields
• Low inflation view being challenged– Risk that wage, commodity and/or protectionism inflationary pressures persist– Imbalances (e.g. inflation versus growth) impacting China’s policy choices– Disinflationary forces still in place e.g. debt overhang and Asian devaluation
• Caution in risk assets supports opportunities elsewhere– Further equity and credit market returns dominated by income– Seeking alternative return sources to reduce reliance on broad markets– Diversified alpha as an additional source of value
• Uncertain macro environment to be reflected in higher volatility– Conflict between cyclical and structural drivers will cause increased volatility– Volatility in rates and FX reflects uncertainty; equity volatility unsustainably low– Long-term impacts from the misallocation of capital (e.g. through leverage)
Source: Invesco Perpetual as at 28 February 2017. For illustrative purposes only. Views and opinions may change.
11 Are return targets realistic in today’s markets?
6. Investment ideas: how to achieve our income and return targets as economic conditions change
Within the final part of this paper, we discuss how a flexible multi asset portfolio can access different return streams in order to generate returns, despite the challenging economic backdrop discussed above. We focus on current market dynamics and how we size ideas to contribute to our income and return targets.
Idea 1: Using volatility as an asset typeOne conclusion from our previous comments is that being restricted to risk premiums and long only investment options could limit the ability of a multi asset investor to achieve targeted returns in a low nominal growth world. So, the flexibility to invest across different asset types rather than be constrained by traditional asset class buckets is essential.
One asset type that can provide a support for returns in this environment is volatility. As returns on equities and fixed income are eroded, volatility often increases. Figure 15 shows the policy uncertainty index versus the realised volatility of equities over time. There has historically been a very close correlation between the two. However, investors are right to question the recent divergence between the two series where equity volatility has fallen as policy uncertainty has continued to rise.
This divergence has placed a question mark over how a multi asset fund, which typically uses derivatives, can deliver its return objective in an environment in which volatility has continued to decline. It has been a surprise as to how volatility has continued to fall despite ongoing policy uncertainty. However, perhaps, when we break down the drivers of the equity risk premium and how expectations influence equity markets, it may be less surprising.
Equities are driven by forward growth expectations and those forward growth expectations are built into an expectation of future cash flows, which are
discounted using a discount rate. As long as the discount rate is below the nominal growth rate then equities can continue to follow a fairly sanguine path. The more recent concentration of policy changes and uncertainty across financial markets has had a greater influence on the volatility of other asset types, such as currencies and interest rates, rather than equities. The two charts in figure 16 show how the implied volatility of both interest rates in the UK and the US dollar have risen in response to that policy uncertainty. If the volatility of these two asset types continues, it should eventually feed through to higher equity market volatility because of the knock-on effects of a higher discount rate as policy is tightened, offsetting improved growth expectations for equity market valuations.
We believe this provides a very attractive return opportunity for a flexible multi asset portfolio. As unconstrained multi asset investors, we are able to buy volatility directly. This can be across different asset classes and can produce positive returns in periods during which core asset classes are under pressure, for example, due to a re-pricing of the global growth or policy outlook.
We can also take advantage of the elevated levels of implied volatility within currency markets. The UK pound has fallen significantly over the past year and, as a result, the level of implied volatility of the pound has risen because investors have been willing to pay a premium to buy options to protect further downside currency risk. For example, one of our current investment ideas is based on selling put options on the cross currency rate between the UK pound and the US dollar to earn an income.
Idea 2: Currency ideas as policy divergesPolicy uncertainty can also be a catalyst for policy divergence. Typically, there is an effort to co-ordinate monetary policy while going into and during an economic downturn. However, economies often
Figure 15Investors are questioning the current divergence between policy uncertainty and equity market volatility
Policy uncertainty VIX index (RHS)
Index Index
5
15
25
35
45
55
65
0
50
100
150
200
250
300
1/90 1/93 1/96 1/99 1/02 1/05 1/08 1/11 1/14 1/17
Policy uncertainty, lhs VIX (RHS)
Source: Thomson Reuters Datastream. Data as at 31 January 2017.
12 Are return targets realistic in today’s markets?
emerge with different imbalances and different risks, which, in turn, require a different policy response as they recover. This is exactly the issue that the global economy is facing today. The Fed is cautiously raising rates, the ECB is keeping policy incredibly loose and China is trying to work out how to slow
down the effects of the credit creation that it has fuelled over the past few years. In other words, when growth rates slow, relative winners and losers emerge and these can create opportunities for a multi asset portfolio, which has the flexibility to take relative value positions.
Figure 16Volatility has risen in interest rates and currencies
Policy uncertainty Implied volatility of UK 10y interest rates (RHS)
Index bps
40
48
56
64
72
80
0
50
100
150
200
250
1/05 1/07 1/09 1/11 1/13 1/15 1/17
Pol Uncertainty (LHS)
Implied Vola UK 10y interest rates (RHS)
Policy uncertainty Implied volatility of the trade-weighted US dollar (RHS)
Index %
0
5
10
15
20
25
0
50
100
150
200
250
1/98 1/01 1/04 1/07 1/10 1/13 1/16
Pol Uncertainty (LHS)
Implied volatility of the trade weighted US Dollar
Source: Thomson Reuters Datastream. Data as at 31 January 2017.
Figure 17The implied level of UK pound volatility remains relatively high
GBPUSD GBPUSD 1-year at the money implied volatility (RHS)
GBPUSD %
6
9
12
15
1.2
1.4
1.6
1.8
1/12 1/13 1/14 1/15 1/16 1/17
GBPUSD Curncy GBPUSDV 1year Curncy
Source: Bloomberg. Data as at 27 February 2017.
13 Are return targets realistic in today’s markets?
Currencies are one of the simplest ways to capture a policy-related relative value idea. After the 2001 downturn, policy across central banks started to diverge. The Royal Bank of Australia (RBA) was the first to raise rates in 2002, followed by the Bank of England (BoE) in late 2003 and then the Fed in mid-2004. This divergence in policy was reflected very directly in the relative moves in the currencies. Figure 18 shows that as interest rates increased in Australia but continued to fall in the US, the Australian dollar appreciated by over 60% versus the US dollar. Over the same time period, global equities fell. It is being able to access this type of opportunity that is invaluable for a multi asset fund hoping to achieve return targets over the long-term.
One current investment idea in our Invesco Global Targeted Returns strategy is buying the Indian rupee versus the Chinese renminbi. This investment idea was originally based on the relative differences being created by economic and policy reform in India while at the same time, Chinese authorities were trying to maintain the country’s global competitiveness. In addition, more recent developments have put a
question mark over China’s policies, which have provoked outflows from China leading to currency weakness. The different economic and policy priorities and the responses of central banks at this point in the economic cycle are examples of how returns can be generated outside of the core asset classes for a multi asset portfolio.
We generate a central return expectation for each idea in our portfolios and then use that return expectation to size each idea to contribute between 25 and 50bps annually to returns at a portfolio level. When this idea originally entered the Invesco Global Targeted Returns strategy, in September 2014, the central return forecast was 5.6%. Therefore, we originally sized the idea at 5% for the idea to contribute 28bps at the fund level (5% multiplied by the 5.6% expected return).
Idea 3: Sector and country opportunitiesAs discussed, during an economic transition when investors re-price the global growth, inflation and/or policy backdrop, winners and losers tend to emerge.
Figure 18Diverging monetary policy drove the Australian dollar higher
US Fed Funds rate Australian target interest rate Australian dollar vs US dollar (RHS)
%
0.4
0.5
0.6
0.7
0.8
0
2
4
6
8
1/00 1/01 1/02 1/03 1/04 1/05
US Fed Funds Australia target interest rate Australia dollar vs. US dollar (rhs)
Source: Thomson Reuters Datastream. Period covered 1 January 2000 to 1 January 2005.
Figure 19Policy differences have driven rupee appreciation against the renminbi
14 Are return targets realistic in today’s markets?
Notes1 We cannot guarantee that the strategies will achieve their return targets or preservation of capital; your clients may not get back the
amount they invest.2 Source: Thomson Reuters Datastream local currency equity sector indices data from 1 January 1977 to 1 February 2017.
7. Conclusion
Within this paper, we have discussed the potential risks to targeted return strategies in achieving their return objectives. A lower nominal growth environment lowers the potential return available from traditional asset classes because it challenges metrics such as the equity risk premium and the equilibrium level of interest rates for both bond and equity valuations. Within a multi asset framework, however, if an approach can step away from the constraints of traditional asset class investing and broaden the opportunity set to include alternative
If growth is scarce, it is even more important to be exposed to the right sectors of economies and markets. Japan is an example of this as it has experienced such a low growth environment for an extended period of time. As a starting point for analysis, we have calculated the standard deviation of relative returns of Japanese sectors through time. Since 1980, the standard deviation of year-on-year returns of sectors in the Japanese equity market has been higher than the US over the same time frame: 10.5% for Japan versus 9% for the US equity market.2 However, even within the US market, if we segregate the data since 1980 based on low, high and negative quarterly GDP growth, during periods of negative growth the dispersion of sector returns is highest. In addition, we see that the dispersion of returns during low growth phases is higher than during periods of high growth. This makes sense because during periods of strong growth, all sectors of the economy do relatively well. It is as growth slows or stalls, depending on which phase of the economic cycle we are in, that the dispersion of returns tends to increase. Indeed, there is a negative 30% correlation between quarterly changes in GDP growth and the dispersion of US sector quarterly returns. We can utilise this theme directly by buying one sector and selling another sector to potentially gain access to return generating investment opportunities.
One relative value equity idea, which we added to the portfolios in 2017, seeks to extract the relative value opportunity of French versus German and Italian equities. There is a valuation case for favouring France over the other two markets and, in this
environment, where underlying growth drivers are coming under pressure, we believe France could outperform. This idea is attractive from both a total returns and income perspective because we believe both the total return of the idea and the income contribution will be positive over the next three years.
Figure 20Negative and low growth phases see a greater dispersion of equity sector returns
• US sectors • Japan sectors
8.7%
7.3%
13.0%
9.5%
7.9%8.4%
Low growth High growth Negative growth
US sectors Japan sectors
Source: Thomson Reuters Datastream local currency equity sector index data in Japan and US, total return. Period covered 1 January 1977 to 1 February 2017.
asset types, as well as employ different styles of investing, the flexibility of that approach should underpin a strategy being able to deliver a long-term return target throughout the cycle. This is exactly what we aim to do in our portfolios. We believe that our unconstrained approach to investing in good, long-term investment ideas, all of which we expect to deliver a positive return over time, should underpin our ability to meet our return and volatility targets across our portfolios.
15 Are return targets realistic in today’s markets?
Appendix: Performance of the Invesco Global Targeted Returns Fund
Returns 3 months 6 months 1 year 3 years Since inception* 2014 2015 2016(annualised) (cumulative) (annualised) (calendar
* Inception date 18 December 2013. ** Performance figures are shown in euro, inclusive of reinvested income and gross of ongoing charges and portfolio transaction costs. The figures do not reflect the entry charge paid by individual investors. Reference index source: Bloomberg, in euro. *** Fund (A Accumulation EUR share class) performance figures are shown in euro, inclusive of reinvested income and net of ongoing charges and portfolio transaction costs. The figures do not reflect the entry charge paid by individual investors. Source: Invesco as at 28 February 2017. The performance data shown relates to a past period, which is not a guide to future returns.
16 Are return targets realistic in today’s markets?
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Important informationThis marketing document is exclusively for use by Professional Clients and Financial Advisers in Continental Europe (as defined below) and Ireland, Qualified Investors in Switzerland and Professional Clients in Dubai, Jersey, Isle of Man, Malta, Cyprus and the UK. This document may also be used by financial intermediaries in the United States as defined below. This document is not for consumer use, please do not redistribute. Data as at 28.02.2017, unless otherwise stated. This document is not subject to regulatory requirements that ensure impartiality of investment recommendations and investment strategy recommendations. Therefore, the prohibition of trading before the release of investment recommendations and investment strategy recommendations does not apply. Past performance is not a guide to future returns. Where Georgina Taylor has expressed views and opinions, these may change and are not to be construed as investment advice. 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