Investment Philosophy White Paper The Centuria Solution: Achieving superior returns in a volatile new world
Centuria Capital Limited
The Centuria Solution: Achieving superior returns in a volatile new world
Contents 00
The new investment environment: here to stay
01
Weighting the portfolio: a new respect for volatility
02
Investing in the new reality: the role of tactical asset allocation
03
Setting expectations: getting real
04
The future: living with the new reality
“ Instead of continuing to regard the current environment as the ‘tail end’ of the GFC ‘anomaly’, we need to make plans based on the expectation that the conditions of the past six or so months – or in fact longer – are our new reality. ”
Disclaimer: This paper has been prepared by Centuria Capital Limited (“Centuria”) ABN 22 095 454 336 on behalf of Centuria and its related bodies corporate, including Centuria Life Limited (AFSL 230867) and Centuria Property Funds Limited (AFSL 231149). This paper is only available to investment professionals and must not be distributed to or relied upon by any other person. Any financial advice contained in this document has been prepared without considering your objectives, financial situation or needs. Before acting on any advice, you should consider whether it is appropriate to your situation and it is recommended you obtain financial, legal and taxation advice before making any financial investment decision. Information in this document is not an offer or solicitation for the purchase of securities, units or investments. Whilst Centuria has taken due care in the preparation of this paper, no representation as to its accuracy is made. Readers are cautioned not to place undue reliance on information in this presentation, including forward looking statements.
Centuria Capital Limited Investment Philosophy White Paper
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00. The new investment environment: here to stay
There’s been considerable focus in the past six months or so on the ‘new’ volatility of world markets. The convergence of various geopolitical and other macro factors such as European sovereign debt, when combined with the hangover from GFC Mk 1 and unprecedentedly fearful investor sentiment, has had a profoundly unsettling effect on market movements. In fact, volatility levels across all major asset classes in the four years since September 2007 have increased – and in some asset classes that increase has been as much as four- or even five-fold compared to the four years prior (see chart on page 3, Annual Volatility). Given the longstanding nature of a number of root causes of this volatility, most pundits predict that this new and uncertain market environment is here to stay, at the very least out to the medium term. Geopolitical factors such as political unrest in northern Africa and the Middle East, for example, the likely persistence and intensification of sovereign debt issues in many peripheral nations of the Eurozone, the US debt and apparent lack of political will to address it, and European corporate pension fund deficits along with lingering concerns about inflation and the slowing of growth in some emerging markets – notably China – are all issues that are unlikely to be resolved in the shorter term. They can therefore be expected to continue affecting both markets and investor sentiment for some time to come.
Time for a line in the sand
What this means for investors and, more particularly, for investment managers, is that the time has come to draw a line in the sand. Instead of continuing to regard the current environment as the ‘tail end’ of the GFC ‘anomaly’, we need to make plans based on the expectation that the conditions of the past six or so months – or in fact longer – are our new reality. We need to take a fresh new look at market conditions and change our investment philosophies accordingly. By this, we mean all aspects of our investment philosophy – in terms of our allocations, our whole consideration and weighting of risk, and right down to the way we physically manage a portfolio. Most emphatically, what we must avoid is clinging to the investment habits, models and management styles that were informed – or, some might argue, misinformed – by the ‘normal’ that preceded the GFC – or GFC Mk 1, depending on your view. Because to do so will, in Centuria’s view, most certainly destine us for failure. In this whitepaper we take a look at some of the new approaches Centuria is taking in order not only to come to terms with and effectively address this new reality in our investment planning, but also, wherever possible, to turn it to the advantage of our investors. This new approach has arisen from a combination of extensive independent research and consultation and modelling and projection undertaken by our own investment committee.
The Centuria solution
Generally speaking, our solution comprises three parts. First, it requires us to look at the relative risk and returns of different asset classes in a whole new light, and to adjust our approach to portfolio weightings accordingly, based on factors that will often run counter to accepted wisdom. In so doing, it calls upon us to adjust old expectations and make our decisions based on what we know now – not what we knew then. Second, it requires a shift toward a more active, tactical approach to asset allocation – one which allows more frequent reallocation within a larger strategic framework. This involves a genuine paradigm shift and calls for the sidelining – if not the discarding – of the ‘set and forget’ school of strategic asset allocation which has been the norm for so many asset managers for so many years.
The Centuria Solution: Achieving superior returns in a volatile new world
The Centuria solution (continued)
Third, it’s an approach that, in line with the paradigm shift, means we need to be open to outcomes that may initially seem less appealing than those informed by entrenched expectations based on historical market performance. Because the fact is, we can no longer expect those patterns of the past to repeat – or certainly not in the medium term and quite possibly for much, much longer. In short, we need to manage expectations intelligently and in line with what’s realistic according to the evidence. It also means that the days of the ‘she’ll be right’ asset manager are well and truly over. Centuria firmly believes that vigilant attention to both markets and the macro environment, rigour in research and having the courage of our convictions, are what will be required to achieve low volatility and steady returns in the face of the new reality. Accordingly, we present this whitepaper to provide more detail around our position.
01. Weighting the portfolio: a new respect for volatility
Volatility has always been an expected feature of the markets. However, for many years, they have been stable enough to lull many investment managers into ranking it somewhere after consideration of returns in their investment planning. One reason for this was that, prior to 2007 at least, more recent historical experience led them to believe that the combination of lower peaks and troughs and timing of the investment cycle allowed for recovery – and indeed increase of – values in the face of volatility, if only one left assets where they were for say, three to five years. In other words, the ‘set and forget’ approach. The study of behavioural finance tells us that humans have a tendency to consider what has happened in the recent past as the norm, and certainly that is how the relatively benign volatility environment came to be viewed in the lead-up to the GFC. Memories of major shocks, or what are often termed ‘black swan events’, had faded: the oil shocks and inflation crisis of the early - to mid-70s, the 1987 crash, tech-wreck, Asian crisis and devastation these events wrought on the markets being cases in point.
A false sense of security
However, as the following charts clearly show, such a sense of security was false indeed. The volatility across asset classes exhibited in the years preceding the GFC bore no relation whatever to the extremes in the four years that followed. Axioms about ‘time in the market, not timing the market’ are ringing hollow indeed for investors still seeking to recoup the original value of many investments, let alone any returns. And all of this despite following the conventional wisdom of the time and staying in the market for the allotted ‘long term’.
Annual Volatility
30.00% 25.00% 20.00% 15.00% 10.00% 5.00% 0.00%
Australian Equities
International Equities
Listed Property
Fixed Interest
Nov 2003 to Oct 2007
Cash
Unlisted and Direct Property
Sept 2007 to Aug 2011
Source: Rice Warner
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But the story doesn’t end there. Because the benign levels of volatility the markets exhibited in the years preceding the first GFC crisis were not only low compared to the years that followed – they were also very low in historical terms, as the following, longer-term, chart clearly shows.
Annual Volatility
25.00% 20.00% 15.00% 10.00% 5.00% 0.00% Australian Equities
International Equities
Listed Property
Fixed Interest
Cash
Unlisted and Direct Property
Sept 1993 to Aug 2011
Source: Rice Warner
In other words, short memory syndrome had clearly kicked in. As a consequence of failing to adequately factor in the volatility risk, most asset allocations were simply not designed to withstand the kind of pummelling that the dramatic swings in value caused them. This is particularly the case where the ‘set and forget’ mentality, which is underpinned by the belief that the market will ‘come good’ in time – just like it always has – is at play.
02. Investing in the new reality: the role of tactical asset allocation
Against this backdrop, it is our fundamental contention that the continuing high levels of volatility expected in the markets will be too much for a traditional strategic or longer term approach to adequately withstand while still delivering the kind of returns investors require – in particular to support their retirement funding needs. We would also like to make it quite clear that, we are not suggesting that we throw out the strategy baby with the bathwater. We recognise that an overarching long term strategy that’s designed to meet specific investor aims is essential for investment success. However, whereas under the more benign conditions of the past it may have been sufficient to let the market do the work, with only mild and infrequent recalibrations, the foreseeable investment future now calls for a dramatically different approach. Centuria suggests that a shorter term, more tactical approach is now required both to ‘inoculate’ the portfolio against the new volatility – and to boost its performance.
The Centuria Solution: Achieving superior returns in a volatile new world
Use what we know now, not what we knew then
This more tactical approach differs from what has been, for many, the norm in a number of major respects. First, it elevates consideration of volatility and its potential effect on returns to a far higher level than has been usual in the recent past. In so doing, it is in effect reframing some common approaches to risk and return – and thus the weighting of the entire portfolio. To achieve an effective reweighting in this manner requires rigorous modelling and exhaustive scenario planning to provide a range of options from which investment managers can choose, in line with the risk tolerances and the other investment aims of their clients. And, while certainly scenario planning and modelling is far from new, what is new in our approach is the fact that the modelling is taking place with volatility as an uppermost consideration.
A model example
Take the theoretical example of a fund whose objective is to provide a long term rate of return of 7% after all fund expenses, while limiting the short term variability of capital due to market movements to less than 5%. Let’s assume this fund has a current strategic allocation and ranges as below.
Strategic allocation and range Sector
Allocation
Range
60%
0% - 85%
0%
0% - 85%
Property ( i )
10%
0% - 33%
Australian Fixed Interest
15%
0% - 95%
0%
0% - 95%
15%
5% - 100%
Australian Shares International Shares
International Fixed Interest Cash
( i ) Unlisted high quality commercial property subject to gearing on any one property being no more than 50%
In order to look at future allocations, it is necessary to take an overview of past returns and volatility, and then use a prospective method to determine possible future outcomes – for example as appears in the following table:
Assumed future returns and volatilities Sector Measure
Mean: Standard Deviation:
% p.a.
Australian Fixed Interest % p.a.
% p.a.
7.45
6.75
5.10
4.70
20.90
10.00
4.60
2.80
Australian Shares % p.a.
International Shares % p.a.
Property
7.45 15.90
Cash*
* Note these returns are assumed to be before tax yet after fees.
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Calculations in all tables are courtesy of Rice Warner 5.
In this case, and again theoretically, a range of alternative allocations may be modelled and compared with the current one, using the above presumptions. These could include, for example:
Range of alternative allocations Current
Benchmark 1
Benchmark 2
Benchmark 3
Benchmark 4
60%
40%
20%
10%
20%
0%
0%
0%
0%
0%
Property ( i )
10%
15%
15%
15%
20%
Australian Fixed Interest
15%
25%
45%
55%
40%
Cash
15%
20%
20%
20%
20%
Total
100%
100%
100%
100%
100%
Sector Australian Shares International Shares
( i ) Unlisted, high quality commercial property subject to gearing on any one property being no more than 50%.
Once the presumptive volatility and return information is applied to each benchmark allocation, a clearer picture of likely future returns as against likely volatility emerges:
Expected volatility and return of each alternative allocation Current
Benchmark 1
Benchmark 2
Benchmark 3
Benchmark 4
Expected Return
6.6%
6.3%
5.8%
5.5%
5.9%
Expected Volatility
9.3%
6.7%
4.3%
3.5%
4.4%
1 year Prob
<CPI 1
32.6%
29.2%
23.9%
20.8%
23.6%
5 year Prob
<CPI 2
18.5%
12.8%
7.1%
5.8%
6.5%
Sector
1 The probability of not achieving a return of at least an increase in CPI (after fees and tax) over one year. 2 The probability of not achieving a return of at least an increase in CPI (after fees and tax) over five years.
Given the clear investment aim is for reduced volatility over higher returns, after modelling takes place, Benchmark 3, offers the closest to the desired return/volatility profile, with a minimal reduction in returns (from 6.6% to 5.5% in Benchmark 3) for a very significant reduction in volatility (9.3% to 3.5% in Benchmark 3). So in the current asset allocation the ratio of return to volatility is 0.71 whereas in Benchmark 3 the ratio is 1.57, i.e., investors are receiving 1.57 units of return per unit volatility as opposed to 0.71 units in the current asset allocation model. So by focussing on volatility we have more than doubled the ratio of return to risk with only a minimal decrease in the overall return. Calculations in all tables are courtesy of Rice Warner
The property example: high yield and low volatility
In the new allocation, for example, the weighting to unlisted property is doubled to 20%, with a strategic range increased from the original 0% - 33% to 0% - 40%. This is because modelling shows that the net result of including this higher allocation significantly decreases the volatility of the entire portfolio, without significantly compromising returns. Itâ&#x20AC;&#x2122;s an acknowledgement of the high yield, low volatility nature of unlisted property compared to its listed counterpart, whose performance and volatility closely tracks that of the much higher volatility asset class, equities.
The Centuria Solution: Achieving superior returns in a volatile new world
The property example: high yield and low volatility (continued)
The chart below, for example, clearly shows that for a small trade-off in returns, unlisted property delivers only a fraction of the volatility of both listed property and Australian equities.
Annual average volatility: unlisted and direct property; listed property; Australian equities 12.00%
Average Annual Return
10.00%
8.00%
6.00%
4.00%
2.00%
0.00% 0.00%
5.00%
10.00%
15.00%
20.00%
25.00%
Average Annual Volatility Unlisted and Direct Property
Australian Equities
Listed Property
Source: Rice Warner
The process of modelling which focuses on the net effect on volatility of inclusion of various assets in various proportions in a portfolio is clearly beneficial in determining the likely risk of losses in the current market environment. It is an approach that Centuria is now taking in relation not only to our own funds, but also in our conversations with major institutional investors seeking access to the benefits of the kind of quality unlisted property in which our Property Funds division specialises. For information about unlisted property and its performance – including Centuria’s groundbreaking Investor Rights initiatives, you can find a recent whitepaper on the subject on our website at www.centuria.com.au, in the Articles and Resources section in Property.
A wider remit and a more active approach to achieving long term goals
In addition to a new slant on modelling as described, our new approach also differs from others in that it requires consideration of more widespread and often shorter term factors that may not previously have been thought meaningful influencers of longer term returns. This in turn calls for far greater awareness and monitoring of, for example, macroeconomic factors such as geopolitics and their potential effect on the portfolio. In line with this, it also requires investment managers to be open to and prepared to act upon those shorter term factors by making more frequent reallocations: what we term ‘tactical tilts’, to either safeguard or improve performance. We are looking at an investment approach that might entail the yearly or even more frequent shifting and recalibration of its key assets in order to support the broader, long term strategy. This more fluid feature of an investment policy must also be disclosed and agreed upon in the relevant constitution or trust agreements of the investments concerned, and the governance required must clearly be robust. In saying that we are advocating something very different from the received ‘staying the course’ wisdom, we also stress that we are in no way suggesting a trading approach. In summary, while long term and overarching strategic goals remain paramount, the best means of achieving them are changing significantly. And it is those who understand this and are ready to work with it, not against it, who will succeed.
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03. Setting expectations: getting real
Another necessary feature of Centuria’s new investment approach is appropriate open communication with and education of the investor – be it an individual or an institutional client – regarding the realistic likely outcomes of their investments. The giddy equity market highs and sustained periods of growth that occurred at certain times over the past five to seven years are unlikely to be repeated any time soon. However, as previously noted, humans being inclined to treat their most recent experience as the norm means it is more than likely that some investment managers will be slow to realise it. Just as it is important for investment managers to make their investment decisions based on the new reality, it is equally important that they set realistic expectations and understand the likely net effect of poor performance due to volatility on ultimate returns. Depending of course on the intentions of the investor, this may well involve less glamorous and exciting returns than the surging gains of a bull market. Many investors may instead have to be satisfied with steady, comfortable growth that provides them with a level of security that any option with potential for more stellar returns will not. Take, for example, the Centuria Capital Guaranteed Bond. Glamorous and exciting – not. However, its strong and steady performance during the GFC as the equity markets crashed and burned around it lent it a cachet that would have been difficult to imagine in the pre-crash days. The chart below clearly illustrates the fortunes of the Centuria Capital Guaranteed Bond compared with that of the equity market.
The value of $100 invested in the Centuria Capital Guaranteed Bond in November 2007 compared to other major growth asset classes 140 120 100 80 60 40 20 0 Nov - 07
May - 08
Nov - 08
May - 09
Capital Guaranteed Bond
Nov - 09
Australian Equity
May - 10
Nov -10
International Equity
May - 11
Listed Property
Source: Morningstar Adviser Workstation © 2011 Morningstar, Inc. All rights reserved. Neither Morningstar, nor its affiliates nor their content providers guarantee this data or content to be accurate, complete or timely nor will they have any liability for its use or distribution.
Its performance offers a salutary lesson from which many investors may well be advised to learn. Because, in the new reality, for many risk averse and even mainstream investors, guarding against loss should become equally as important as making gains. This is especially the case in our mandated defined contribution superannuation environment, where people have no choice but to invest. Given the losses so many super account balances have taken, any approach which focuses on preserving, rather than risking, capital, is bound to appeal. Or should.
The Centuria Solution: Achieving superior returns in a volatile new world
Returns always count: debunking the ‘return path’ myth
What’s vital to understand in our new environment is that the figures clearly show that the path of returns on investment always count. Any extended period of underperformance is likely to have an effect on investment outcomes – or, for the purposes of superannuation – ultimate account balances. And, what is little understood is that, under certain circumstances, the impact of poor returns in the early stages of the accumulation phase is likely to have the most profound negative effect of all. The focus of media, political and financial commentary has tended to be on the outcomes of poor investment performance late in the accumulation phase, Centuria’s modelling clearly shows a return path in which the effect of poor performance early in the piece can in fact be far more devastating, depending on the degree to which funds are drawn upon. This is clearly shown in the charts below, which show investment outcomes under three scenarios with the same expected annual investment return of 7%. In the “Good Late” scenario, the investment return is assumed to be -2% per annum for the first five years; and 10% per annum for the 15 years following. In the “Good Early” scenario, returns are assumed to be 10% per annum for the first five years, and 6% per annum for 15 years after; in the “Level” scenario; the investment return is assumed to be 7% throughout the 20 years. In the case of a lump sum investment at the start of the period, it is clear that a poor return in the earlier years has a dramatic impact on the investment value. It takes 20 years to catch up the value impact of the poor return in the early years. This is not a good outcome in the event the investment needs to accessed prior to year 20. Initial investment of $1,000 with average return 7% p.a. after 20 years 4,500 4,000 3,500 3,000 2,500 2,000 1,500 1,000 500 0 0
1
2
3
4
5
6
7
8
9
10
11
Good Late
Source: Rice Warner
12
13
14
Good Early
15
16
17
18
19
20
Level
In the second graph the impact of the path of returns is dramatically demonstrated by showing an investment of a lump sum and then a withdrawal of $1000 per annum thereafter. Clearly the path of returns in the withdrawal phase is even more critical as a poor early period return does not recover. In fact after 20 years the difference in wealth between a level return and poor early period return is over four times. Initial investment of $15,000 with average returns of 7% p.a. with annual withdrawals of $1000; value over 20 years 20,000 18,000 16,000 14,000 12,000 10,000 8,000 6,000 4,000 2,000 0 0
1
Source: Rice Warner
2
3
4
5
6
7
8
9
10
Good Late
11
12
13
Good Early
14
15
16
17
18
19
20
Level
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While other scenarios produce somewhat different results – see below – it is clear that aiming for even a small increase and no loss is, while unexciting, in all cases likely to produce superior long term results.
Initial investment of $1,000 with average return 7% p.a. and investment of $1,000 a year over 20 years 60,000 50,000 40,000 30,000 20,000 10,000 0 0
1
2
3
4
5
6
7
8
9
10
Good Late
11
12
13
Good Early
14
15
16
17
18
19
20
Level
Source: Rice Warner
04. The future: living with the new reality
While in Centuria’s view the new reality described in this whitepaper is here to stay, we also believe that some elements in the asset management and investment community have been slower to realise it than others and understand that it will continue to be a source of contention in the investment community for some time to come. This is especially the case as the Australian love affair with equities has been a passionate one, one that has endured and will likely involve a long, slow and painful breakup. That being said we believe that the evidence is clear. Volatility is here to stay, and in order to best serve the investor, the sooner steps are taken to reduce its negative effect on portfolio returns through canny modelling and considered portfolio weighting; remaining more highly attuned to worldwide market and geopolitical conditions; and being open to more tactical, short term reallocations and ‘tactical tilts’ in our portfolios, the sooner we will learn how to make the new reality work for us rather than the other way around.
The Centuria Solution: Achieving superior returns in a volatile new world This paper has been authored by John McBain.
John McBain Chief Executive Officer Centuria Capital Limited John joined the Centuria Board in July 2006 and was appointed CEO in April 2008. John was the founder of property funds manager, Century Funds Management, which was established in 1999 and acquired by Centuria in 2006. Prior to forming Century, John founded property funds manager Waltus Investments Australia Limited in 1995. Waltus was one of the first dedicated unlisted property funds managers in Australia. John is a director of subsidiaries Centuria Strategic Property Limited, Centuria Property Funds Limited and Centuria Life Limited and a director of an associated company Mortgageport Management Pty Limited. John serves on the Investment Committees of both Centuria Life Limited and the Over Fifty Guardian Friendly Society Limited. John qualified in property valuation in New Zealand and from 1990 to 2006 was involved in both commercial property consulting and the growth of the unlisted property fund market in Australia. Prior to 1990 John spent four years as managing director of a specialist commercial property investment company based in the United Kingdom.
Centuria Capital Limited Level 30 367 Collins Street Melbourne VIC 3000 T: 1300 CENTURIA F: 03 9629 3397 E: melbourne@centuria.com.au www.centuria.com.au