Liam O’Reilly

Over the last 12 months, the S&P ASX 200 delivered +12.1% returns (as at 30/06/2024), lagging global markets by over 8%.

While that divergence in returns is disappointing at an index level, those investors who looked to utilise active management generally experienced even worse outcomes. The Australian equity manager peer group (based on FE’s AMI Equity – Australia index) underperformed the ASX 200 by 3.04%, the 2^nd worst relative return result of the last 10 years. This article will look to identify some of the common themes that have led to such an outcome and what that means for investors going forward.

For comparison’s sake, it is often valuable to examine Australia within the international context. Over the last 12 months, much has been made about the concentration of global equities’ stellar performance, with the ‘Magnificent 7’ (which consists of NVIDIA, Microsoft, Amazon, Meta, Alphabet, Apple and Tesla) leading the charge. This phenomenon has been discussed ad nauseam, but for good reason, with nearly 50% of the S&P 500’s +24.09% return being generated by the Magnificent 7. This is remarkable when you factor in that Tesla was the index’s worst contributor, subtracting -0.56% from overall returns.

While mega-cap technology with exposure to the AI thematic was the lead story among investors, it can also not be discounted how enamoured market participants were with the development in GLP-1 drugs, which are being touted as the solution for the global obesity epidemic.

Both thematics could warrant their own article on whether the performance leadership and valuations are justified. However, a clear argument can be made that the potential for structural change as a result of these companies’ underlying products and services can justify, at least in part, what we’ve seen from global markets over the last 12 months.

Looking to Australia, the concentration of performance has been far worse, yet the same underlying themes are (almost) nowhere to be seen. While global investors have been piling into potentially society-changing technology and medicine, domestic investors have been predominantly loading up on cyclical giants. Of the ASX 200’s total return over the year, 70% of it can be attributed to the Index’s 8 largest companies by average market capitalisation over the 2024 financial year (iBHP, Commonwealth Bank, CSL, NAB, ANZ, Westpac, Wesfarmers and Macquarie).

Doing a similar exercise as with global equities by substituting BHP (which detracted from index performance) for the data centre exposed Goodman Group, the narrowness becomes even more pronounced. From this comes several important questions: what’s driving this, can it be sustained and what does it mean for active management looking forward?

Of the Australian companies previously mentioned, perhaps the strongest example of the disconnect between active and passive management has been the exposure to the Big 4 Banks. In the last 18 months, we have seen the most aggressive interest rate hiking cycle in decades, rampant inflation and anaemic economic growth. You could be forgiven for thinking that this would not be a conducive environment for the banks, which are so heavily leveraged to the health of the Australian economy. Instead, we have seen relatively flat earnings, historically low levels of bad debts and investors looking to add risk back to their portfolios after a challenging 2022. Consequently, the average returns for the Big 4 Banks has been in excess of 20% over FY24.

Bank exposure has been a sore spot for many active strategies, with the vast majority of fund managers Evergreen has met with holding an underweight position. While many funds took positions when rates initially began rising to capture the benefits of expanding net-interest margins, these positions were exited or reduced long before the full extent of the returns were captured.

Talking to a number of managers with varying approaches, the general logic has been the same: these institutions are trading on excessively stretched valuations, both relative to their own historical averages as well as global peers (see Exhibit 1). Pair this with a fairly cautious outlook for the underlying fundamentals like net interest margins and loan provisioning, which has underpinned a number of sell-side institutions downgrading their ratings^[1],[2] in recent times, and you’re left pondering how these stocks have continued to outperform the market.

One potential source of stock price appreciation has been the sheer scale of inflows into passive index products. As shown in Exhibit 2, this shift from active to passive has been a trend for the last decade which has continued to gather pace. In Australia, the dynamic is the same. In the year following the onset of the Covid-19 pandemic (31/03/2020), passive investments saw inflows in excess of $24billion in Australia. Over the same time period, active funds saw outflows close to $7billion^[3]. While more up-to-date data is not readily available, it is fair to assume that based on global data the trend has continued.

Such aggressive flows into passive products creates somewhat of a self-perpetuating loop. An argument has been made that as the market’s largest companies continued to rally, many active managers that held the names on a fundamental and valuation basis began to sell into market strength. As the number of sellers reduced (due to fewer active managers holding these names) the liquidity in these stocks has somewhat declined, at least in terms of there being willing sellers. As passive investment inflows continued to build, the impact of these funds having to buy these names results in further upwards price pressure. Additionally, institutional ownership (which is a mix of passive and active investors) on the share registry of the Big 4 Banks has seen a roughly 2%-4% increase from relatively stable long-term averages^[4]. This demonstrates the high degree to which large institutions have been purchasing these names, with the large superannuation funds constrained to where they can gain exposure to the market given their increasing scale and liquidity needs.

It has also been reported that a number of Asia-based managers have been seeking exposure to the Australian banks as a way of diversifying away from China^[5]. While it is difficult to quantify the exact impact this offshore interest has had on the Index, it certainly raises doubts as to how sustainable this level of concentrated performance is going forward given that any sign of economic recovery in China could see recent flows into our financial sector reverse.

There have also been a number of other themes that have challenged active managers over the year. The first of these is the idea that the market will pay any price for quality. A good way to examine this is by looking at the multiple expansion seen in some of the market’s top performers for the year, particularly in the consumer discretionary space. Quality attributes common amongst these companies are low leverage relative to peers and a strong market share in their respective industry segment. While the below companies all have quite broad and different customer bases, it is interesting to consider how these stocks have re-rated, despite a challenging economic and earnings outlook.

This multiple expansion supports the idea that markets may be getting ahead of themselves. It appears investors have sought out those names with the perceived highest quality that look best positioned to benefit from a cutting of interest rates and an improving economy. When you compare this expansion to several more defensive quality cyclicals names, it reinforces the idea that momentum has well and truly taken over market dynamics. This is due to the fact that these more defensive companies’ underlying demand should, in theory, be less sensitive to the constant delay in rate cuts which the market has been so desperate for.  While these loftier valuations may be justifiable on the idea that the economic recovery will occur as the market expects, it should also then support the idea of performance broadening out. Such an environment should provide active managers with greater opportunities for alpha generation.

Following on from that is the notion that we have also seen a ‘junk rally’ in select parts of the market. The market psychology observed is perhaps one where investors would rather own a lower-quality company with short-term positive catalysts rather than higher quality companies with temporary blemishes. This was particularly evident in the November/December rally of 2023, where these lower-quality companies (defined by higher leverage, greater earnings variability and a lack of pricing power, evident by their typically lower margins) rallying hard off the back of renewed expectations that the RBA would begin an aggressive rate cutting cycle.  This phenomenon is not a new one with markets historically showing characteristics of over-extrapolating both good and bad news in the short-term. So, while there’s no question that the market has genuine concerns over some of the most notable index laggards, it can be argued that the degree to which the market is willing to look past headwinds for some but not others is somewhat inconsistent.

In summary, there’s no doubt it has been a difficult period for active management. Momentum led markets, a shift to passive investment and a turbulent economic outlook have led to valuations in parts of the market looking increasingly stretched. Meanwhile several more unloved parts of the market continue to trade at depressed valuations, particularly among some of the ASX’s more defensive names. Such divergence in markets means any form of mean-reversion would likely provide an environment where active management could once again prove its worth, by delivering outsized returns and/or deliver capital protection in the event of an unexpected market shock.

In recent weeks, we have already potentially seen this theme begin to playout in the US with markets beginning to rotate out of many of the winners of the past 12 months. This gives credence to the idea that we may see the same thing in August domestically, as the Australian reporting season gets under way. In times like this we must remind ourselves to stay disciplined in our investment approach and ensure we don’t succumb to short-term biases like the fear of missing out.

By Liam O’Reilly

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Notes:
[1] Jones, S. (2024) Macquarie says it’s time to sell the Big Four Banks, Australian Financial Review. Available at: https://www.afr.com/markets/equity-markets/macquarie-says-it-s-time-to-sell-the-big-four-banks-20240314-p5fcdm
[2] Baird, L. (2024) ‘all banks to sell’: Citi sounds big four valuation alarm, Australian Financial Review. Available at: https://www.afr.com/companies/financial-services/we-downgrade-all-banks-to-sell-citi-sounds-alarm-on-big-lenders-20240422-p5flmz?mkt_tok=NDEwLVhPUi02NzMAAAGSxfbPVr4eQbiiuP4cFODIWH1KyV_X0XieEJ7s4pxDLnxZID4WyAjLBdmtr7EFChEKG_VwSlamydoY0QgBZgmomxsXj3rtwl0HrTEmYa2MLuUWgQ
[3] Rapaport, E. (2021) Aussies sink more into passive funds than active, Morningstar. Available at: https://www.morningstar.com.au/insights/funds/213195/aussies-sink-more-into-passive-funds-than-active
[4] Tran, J. (2024) Retail ownership of big banks crashes to lowest level on record, Australian Financial Review. Available at: https://www.afr.com/markets/equity-markets/retail-ownership-of-big-banks-crashes-to-lowest-level-on-record-20240711-p5jsta
[5] Gluyas, A. (2024) Wave of China money piles into Aussie Banks, Fuelling Rally, Australian Financial Review. Available at: https://www.afr.com/markets/equity-markets/wave-of-china-money-piles-into-aussie-banks-20240315-p5fcnp

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Brad Bugg

Over the course of 2024, inflation has continued its downward trend, pushing it back to levels closer to the goals of most central banks. Nonetheless, many central banks around the world continue to warn that the fight against inflation is not done yet and they stand ready to respond should the last leg of the inflation fight not go as expected.  Accordingly, investors should be contemplating the prospect of inflation remaining higher than expected and potentially look to adjust their portfolios by adding some sort of inflation protection to make it more resilient.

Periods of higher-than-expected inflation often make it difficult for many asset classes as it erodes the real return investors receive. Real returns are important as they protect an investor’s purchasing power over time. Therefore, identifying asset classes which may be more resilient to, or potentially even benefit from, higher levels of inflation can be very valuable to an investor’s portfolio.

All investments are impacted differently during periods of higher inflation, but with Australian and International bonds and equities often making up very large proportions, if not all an investor’s portfolio, introducing other asset classes or investments that are more resilient to high and unexpected inflation can help significantly improve portfolio outcomes. Assets that often fare best are those that see their revenues, cash-flows and/or prices linked to movements in the level of inflation. The most common assets and investments displaying this profile are:

• Infrastructure Assets/ Investments
• Property Assets/ Investments
• Inflation Linked or Protected Bonds
• Commodities, notably Gold.

Infrastructure is an asset class that includes companies or investments which provide goods and services, often essential for the operation of an economy that sees them being highly regulated. Often part of the regulatory arrangements is to link future increases in prices and revenues for the goods and services they provide to the prevailing level of inflation. Therefore, when inflation is high, revenues from infrastructure assets will adjust to compensate.

Similarly, certain property assets can benefit from higher levels of inflation as they have rental arrangements that allow for rents to be adjusted higher in line with the prevailing rate of inflation. It is not just the rents seeing protection, as the underlying value of  property has traditionally performed well and outweighing returns from more traditional bonds and equities.

Investors can also seek out protection from more defensive assets, such as bonds that have their coupon payments linked to the level of inflation. These are simply known as inflation linked or inflation protected bonds and are issued by governments and or large companies.

Finally, investors can simply seek out assets whose prices will benefit from the effects of inflation. In this regard, investments which have strong links with commodities have traditionally fared much better than those with no exposure. This exposure can be to explicit commodities themselves, like gold, copper or coffee beans, or to companies which produce/ extract commodities like Energy or Materials companies.

Like any investment, there are factors which investors must consider before taking exposure to any, or a combination of, assets that offer resilience to high inflation. Like any asset, the price at which the asset is being bought should be a key consideration. While the underlying cash flows of the asset may benefit from higher-than-expected inflation, the current price of the asset may already be accounting for, or in many instances overcompensating for the inflation protection benefits, the asset might bring in a high inflation environment.

Investors also need to be aware of how and when cash flows might be adjusted to compensate for increases in inflation. Often the benefits of the inflation linked increases in revenues and cash flows are lagged to when it takes effect. Although the inflation protection benefits will be ultimately realised by the asset, investors need to understand this can often be with a significant time lag.

One final element to consider in relation to infrastructure and property assets particularly is the level of debt or leverage that many of these assets and companies have. With greater certainty around the cash flows these assets can generate, they are able to take on higher levels of debt than what other companies normally might. This element is very important, as it makes the assets much more sensitive to changes in interest rates. This means that when interest rates rise, the negative impact of higher interest costs will exceed the positive benefits that having an inflation linked revenue stream brings.

This last point is the major reason that many infrastructure and property assets have had a difficult couple of years and disappointed many investors in delivering the inflation protection they might have expected. Normally this might be an environment which would be supportive of infrastructure and property performing better than many other asset classes.

However, the period also saw interest rates rise from all-time low levels of near zero, to levels that are now more consistent with long-term average interest rates. Given the magnitude of the move, infrastructure and property were sold down more than other assets due to worries that higher interest rates would impact them more than others.

Infrastructure and property assets were not alone in being negatively impacted by the rising interest rates during this period, as inflation linked bonds also suffered. While they benefitted from the impact of higher inflation, they were disproportionately impacted by the sharp rise in the real yields and the long maturities of many of these types of bonds.

So, in the event that inflation does remain higher than expected moving forward, the big questions for investors is whether inflation linked assets will deliver the inflation protection benefits we would normally expect? Or will there be a repeat of the last couple of years where they failed to deliver the protection expected?

Although no outcome can ever be ruled out, the main element driving the return outcomes in recent years was the magnitude of change in both nominal and real interest rates in a very short period of time. These changes were amongst the largest ever seen in fixed income markets, but probably what distinguishes the period most is the record low levels from which interest rates came. Currently both nominal and real interest rates are at levels which are much more consistent with longer term averages and probably unlikely to move up by the 3% to 4.5% change witnessed in interest rates around the world in recent years. It should be expected that interest rates will likely rise in the event of higher inflation, but looking forward, any adjustments will likely need to be much less dramatic than that seen in the last couple of years.

With the impact of interest rate moves much less pronounced on asset prices, the inflation protection qualities of infrastructure, property and inflation linked bonds will have a much more positive impact on the performance of these assets in the event of high or higher inflation. Such outcomes will allow these assets to play the role normally expected of them in such environments and help deliver the very valuable diversifying qualities to investor portfolios.

In summary, while inflation has made good progress in falling back to central back targets, the fight is not over yet, and inflation could remain elevated or even rise. Given this prospect, seeking exposure to assets which might benefit or offer some protection to higher levels of inflation is likely to enhance outcomes for an investor’s portfolio. However, there are several elements to consider and include issues like how the assets are currently priced, the levels of leverage and the timing of when cash flow adjustments might take effect. Reflecting on more recent outcomes for many of these assets is unlikely to representative of future outcomes with assets like infrastructure, property and inflation having been negatively impacted by one of the largest upward moves, from the lowest level of interest rates in history. A more stable and less volatile interest rate environment will help them deliver the inflation protection and diversification qualities through most other periods of high and unexpected inflation.

By Brad Bugg, Principal Consultant

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Kieran Rooney

Evergreen Consultants has released what they believe to be an important new white paper entitled “The Case for Bonds”. The paper, written by Senior Consultant, Kieran Rooney, considers 120 years of history for bond markets.

It explores bond market returns, the term structure of interest rates throughout varying economic and market environments and how bonds are used within the financial system as collateral using data from the beginning of last century.

The paper also considers in some depth the reason why yield curves invert and the signalling that curves can provide us with respect to economic and financial fragilities. These signals can be prescient and are particularly applicable in the present environment.

Rooney says, “The signalling power of the yield curve cannot be underestimated. Correlation of yield curve inversion with future recessions ranges from 75% to nearly 90%, depending on the part of the yield curve being considered.

“Whilst the efficacy of the yield curve suffers from variable lags, yield curve steepening (that is, the movement from an inverted position to a more normal yield curve) is, in our view, the most prescient sign of financial fragility. We believe this has begun in this cycle.

“In our framework and given our research, current market dynamics tell us that there is a non-trivial probability of recession in many parts of the globe over the next year or so.

“In terms of portfolio positioning and as a result of our work, we also believe that the relative risk/reward currently available from high quality bonds are amongst the best market opportunities available.

“We have been incorporating these views, and extending portfolio duration as part of our portfolio construction advice across managed account clients and other clients as opportunities present themselves.

“We believe the bond market will remain volatile as both markets and economies adjust to a world of both ‘higher-for-longer’ inflation and interest rates. It is an environment which very few market participants have seen or understand.

“Nonetheless, we believe that the opportunity in this asset class is the most interesting it has been for many years.”

Read the report.

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Kieran Rooney, a Senior Consultant at Evergreen Consultants, says standard risk measures, such as standard deviation, can be misleading when it comes to assessing the risk of unlisted assets. This is because assets that do not re-price or trade regularly exhibit low levels of perceived volatility and this may give investors a false sense of security.

Rooney says there is work underway to come up with new solutions.

The biggest allocators to unlisted assets in Australia are retail and industry superannuation funds. Unlisted assets in fund portfolios include private equity, private debt, unlisted property and unlisted infrastructure.

Some large funds allocate close to 50 per cent of their holdings to unlisted assets, saying unlisted assets diversify portfolios and boost risk-adjusted returns.

Rooney says: “During the Covid market drawdowns to the end of March 2020, the median growth super fund fell only 13%. This was despite global equities falling 27%. One major Australian super fund devalued its unlisted real estate and infrastructure assets by 7.5%, despite the listed equivalents falling by 40% and 30% respectively.

“If that fund had to divest those assets in that environment, you could argue that the clearing market price at that time would be substantially less than the fund had accounted for.”

Many large superfunds characterise the risk of unlisted assets as being materially lower than their listed counterparts, even though they are very similar assets that face similar risk and return dynamics.

Fund members are not in a position to make their own judgments about this issue because there is limited disclosure of unlisted asset holdings.

Rooney says views on industry best practice for measuring and presenting the risk of unlisted assets are mixed but there is work underway to come up with new solutions.

For its Heatmap evaluation of super funds, the Australian Prudential Regulation Authority uses a growth/defensive framework that adjusts for the “equity-like” exposure of defensive assets and focuses on long-term returns over multiple timeframes to assess the consistency and sustainability of investment performance.

The Future Fund uses standard volatility and Sharpe Ratio measures in its reporting but in recent times it has adopted a measure called Equivalent Equity Exposure, which also adjusts for the extra embedded risk in defensive assets.

Rooney says another approach into looking how measures can be standardised is to stress test portfolios by simulating various levels of drawdowns for each asset class. Evergreen’s internal data analytics software, GreenVue, can be utilised to assist with this, he says.

“There is no perfect way to account for and report on risk in a portfolio, particularly one containing high weights to unlisted assets. A combination of approaches can assist in monitoring and assessing risk in what can be unconventional portfolios.”

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The Evergreen Responsible Growth Model, issued by Generation Life, an investment bond specialist, has been structured as an investment option within their LifeBuilder investment bond to provide investors with tax-effective, long-term holdings in a portfolio of investments that meet sustainability objectives.

The Generation Life investment bond is also Highly Rated by Lonsec.

The Evergreen Responsible Growth Model has also scored A in Ethos ESG which scores investment products on their responsible investment ability.

It is a multi-manager portfolio, investing in a range of best-in-class investment managers. It has a diversified asset allocation, with benchmarks of 75% in growth assets and 25% in defensive assets.

Investment bonds are tax paid investments, which means that the fund manager pays tax of up to 30 per cent on fund earnings. This is different from the more common unit trust structure, where all income and capital gains are passed through to investors, who are liable for the tax.

SQM says the fund is managed using an investment process that is based on a very clearly articulated investment philosophy, which in turn is based on extensive research.

“The investment process is well structured to support the investment decisions that are required in the management of the fund,” SQM says.

The report adds “The managed fund selection process is one of the most thorough and detailed that has been observed among multi-asset, multi-manager investment managers. It takes advantage of the many years of experience the investment team has in researching investment managers and managed funds.”

The manager selection process includes consideration of a fund’s Evergreen Responsible Investment Grading (ERIG) Index score, which currently grades 670 strategies.

Evergreen Consultants Founder and CEO Angela Ashton says Evergreen is in a position to access investment opportunities that are often missed by other investment bonds, especially in the responsible investing (RI) space.

She adds: “This is the only RI multi manager product offered by Generation Life. Investment bonds are particularly useful in estate planning as they can be set up to pass directly to beneficiaries, providing them with tax-free benefits. This can be a valuable solution for long-term investors who care about their money being invested wisely, as well as doing good for themselves and future generations.”

“To have a Superior rating from SQM on top of being part of the Highly Rated investment bond structure from Generation Life is a good position to be in. We have also recently received an A rating from Ethos ESG, which further cements our Responsible Investment credentials.”

Portfolio holdings include:

• Octopus Renewable Energy Opportunities Fund, which has funded the one-million panel Darlington Point Solar Farm in New South Wales.
• NorthStar Impact Fund, which invests in companies that provide solutions to social and environmental challenges, such as social housing projects, education and health initiatives and better land management.
• Pengana WHEB Sustainable Impact Fund, which invests in companies offering solutions to a range of sustainability challenges, including cleaner energy, environmental services, and sustainable transport and water management.
• Robeco Global Developed Sustainable Enhanced Index Equity Fund, a smart beta approach to passive investing combined with high ESG scores.

Evergreen aims to generate returns of the Reserve Bank cash rate plus 3.5% a year over a seven-year period, after manager fees and tax.

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Angela Ashton

Evergreen Consultants has launched a Responsible Investment Questionnaire that financial advisers can use to help clients select Responsible Investment (RI) products for their investment portfolios.

The RI Questionnaire builds on the successful development of the Evergreen Responsible Investment Grading (ERIG) Index, which was launched a year ago and now houses RI scores for over 670 investment products and 2700 APIR codes.

Evergreen Consultants Founder and Director Angela Ashton says: “With ASIC clamping down on greenwashing and ongoing FASEA requirements, advisers are under more pressure than ever before to have these important conversations with their clients, and we are right there on the journey with them.”

The RI Questionnaire is designed to assist investors in identifying funds that align with their values. It builds and RI Profile for each client, which then produces a list of products that match their preferences.

It asks questions that explore an investor’s attitude to the seven categories of the RI Spectrum that the ERIG Index scores. They are ESG integration, negative screening, norms-based screening, active ownership, positive screening, sustainability themed investment and impact investing.

Using the list of products produced, an adviser can build a portfolio that matches the client’s needs and values.

“Working with advisers is at the core of our business and building this online tool was a logical next step for us on the RI journey,” Ashton says.

“We are hearing a lot in the marketplace that the demands of providing RI advice can be overwhelming. We are in a position to help bridge the gap in RI advice and we are absolutely going to step up and fill that gap.

“Standards 5 and 6 of the FASEA Code of Ethics refer to the need for advisers to ask their clients about their investment beliefs as part of best interest duties. Our client Questionnaire is comprehensive and covers this duty with respect to RI.”

Each RI Profile can be saved and amended as needed or exported as a PDF or an Excel file.

Evergreen is currently offering free one month trials for advisers to familiarise themselves with the Portal. The Portal currently has four Modules – Product Search, Portfolio Construction, Client Questionnaire and Knowledge Library.

Ashton reveals that “We are currently having conversations with various platforms and software providers to further integrate the ERIG Index into adviser workflows, making RI advice even more streamlined.”

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Angela Ashton

Evergreen Consultants endorses the Australian Securities and Investments Commission’s move to rid the superannuation and funds management industries of greenwashing.

ASIC has issued an information sheet for superannuation funds and managed funds, detailing its expectations for sustainability related disclosures.

The regulator said the information sheet simply sets out what was required under existing regulatory obligations, particularly the need to make sure statements about an investment product’s green credential are not misleading. It said being true to label is a regulatory ‘must-have’.

ASIC has reviewed the sustainability disclosures of super and investment products and found there was room for improvement.

Angela Ashton, Founder and Director of Evergreen Consultants, says: “The regulator is determined to have transparency and trust when it comes to representing the extent to which financial products or investment strategies are environmentally friendly, sustainable or ethical. We fully endorse that goal.

“Super and managed funds are keen to present their responsible investing credentials to the market and it is a matter of concern that ASIC has found that some industry participants need to lift their game.”

ASIC said issuers need to use clear labels, define the sustainability terminology they use and explain how sustainability considerations are factored into their investment strategies.

Last year, Evergreen launched a responsible investing index, the Evergreen Responsible Investment Grading (ERIG) Index, which assigns responsible investment grades to fund managers.

Ashton says: “At the time, we noted the absence of a consistent industry approach. Now the regulator has put the industry on notice that it is time for consistency and clear communication. We will do what we can to support that development.”

ASIC has recommended that product issuers use the recommendations of the Financial Stability Board’s Task Force on Climate-Related Financial Disclosures (TCFD) as a framework for disclosure.

It has posed a number of questions for product issuers to use in framing their disclosures, including whether terminology is vague, whether they have clearly stated how sustainability policies are incorporated into decision-making, and whether screening criteria and sustainability metrics have been properly explained.

Ashton says: “Reporting standards in this area are developing quickly, which ASIC acknowledges in the information sheet when it says this is an evolving space.

“Evergreen is ready to work with fund managers to keep on top of these changes.”

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Angela Ashton

Investors, retirees, and financial planners in the current market need to look beyond the standard asset allocation choices of chasing share market beta through passive equity funds and relying on bonds for diversification, a leading investment consultant advises.

Angela Ashton, Founder and Director of investment consulting firm Evergreen Consultants, says it is time for investors to explore the alternatives, including gold, commodities, private credit, unconstrained total return multi-sector funds and real asset funds with holdings such as infrastructure and real estate.

“What we are seeing is a mix of strong, sustained inflation coming through and interest rates rising, with last month’s Fed rate rise the first since 2018. We have reached an inflection point in the cash and bond markets. Rates are going up,” Ashton says.

Evergreen’s view is that the corporate earnings cycle has peaked and equity markets will be more volatile.

“The war in Ukraine is adding to inflationary pressure, labour costs are rising and profit margins are under pressure. Equity investors should move to value or quality to position their portfolios more defensively,” Ashton says.

Evergreen Consultants’ current Long Term Expected Returns Framework says the key considerations in projecting likely investment returns are higher inflation and volatility. Evergreen is forecasting 7.75% average annual growth for Australian equities over the long term, with annualised volatility of 13.5%. This is based on a view that Australia’s long-term equity risk premium (ERP) of 4.5 % will remain unchanged.

Bonds moved extraordinarily in March, with yields moving sharply in both directions, an overall deteriorating trend and the appearance of an inverse US Treasury yield curve, with yields on two-year Treasuries higher than 10-year Treasuries at the end of the month.

“Investing in bonds will be very difficult this year as we expect a lot of volatility. It would not be surprising to see yields rise further from here and it is very hard to know where they will land. Markets are volatile and there is every chance they will overshoot,” Ashton says.

Among the alternatives, the Long Term Expected Returns Framework highlights the strong risk-adjusted returns on offer from Australian and global credit. The outlook for Australian credit is for average return of 3.95% a year, with annualised volatility of 3%, while global credit is expected to return 3.75% a year, with annualised volatility of 3%.

Ashton says credit has the advantage over bonds of having yields set at floating rates, which will rise as interest rates rise. She cautions that there is a greater likelihood that some credit funds will suffer defaults in the volatile trading conditions ahead and many funds are illiquid.

The appeal of real assets is that they can generate predictable income distributions due to stable earnings derived from the underlying asset. Regulation and/or long-term contracts reinforce stable cash flows and capital stability. For investors, this provides excellent visibility into revenues and dividends.

Gold is reconfirming its role as a safe haven holding, rising out of the range-bound position it was stuck in for much of 2021, in response to the Russian invasion of Ukraine and other global tensions. At its current level around A$2500 an ounce, it is close to a two-year high.

“The old investment rules are not going to work going forward,” Ashton says.

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Angela Ashton

With underlying post-pandemic economic and market conditions, namely concurrent inflation and volatility, being an unfamiliar backdrop for investors, there is risk that the Russia-Ukraine situation won’t play out as a typical wartime market recovery, says Angela Ashton, Director and Founder, at Evergreen Consultants.

“Given the current outlook, in our view, traditional safe-haven assets such as cash, gold, long duration bonds, and some highly traded real assets such as commodities, could be considered for portfolios.”

Ashton notes: “If we are to be guided by history, markets often sell-off in the lead-up to an armed conflict due to heightened uncertainty, but typically recover once war has commenced.

“Current underlying economic conditions could mean that market outcomes are less satisfactory if the conflict cannot be contained, especially if central banks make a policy error.

“The best-case scenario is that any conflict and sanctions are short-lived and energy prices retreat to levels that do not add further impetus to rising consumer and producer prices. This will reduce the risk of a policy error and potential for an economic and market malaise.”

While it is reassuring to point to history as a kind of security blanket for ultimate market outcomes, the present situation could play out quite differently, says Ashton.

“In examining sharemarket behaviour over the past hundred years, we think it is particularly important to note that uncertainty in the pre-war phase is mostly focused on what the response of the superpower nation is going to be (typically, this has been the US) and how this might impact financial market liquidity.

“An ongoing high inflation environment would likely be negative for many asset classes.

“While this is not our base case, we will be watching for further evidence on likely inflation trajectories and exploring measures to insulate client portfolios from the new challenges this would bring,” says Ashton.

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Angela Ashton

Key findings

• Quartile One Australian equity funds continue to outperform the S&P/ASX200 and lower quartiles.
• Performance and sustainability aren’t mutually exclusive.
• You can’t judge a fund by its name, mixed bag of funds in top ten.

The Evergreen Responsible Investment Grading (ERIG) Index has released its quarterly Responsible Investment performance survey and the findings show a number of common misconceptions to be untrue.

The survey included over 100 Australian Equities funds, grouped into their ERIG quartile rankings^[1], and compared their performance to the S&P/ASX 200 Index. First Quartile funds, that is those with the highest ESG credentials, outperformed the benchmark by over 0.5% per annum over the past three years, after all fees.

This is consistent with the previous quarter’s results.

These funds also outperformed the growth and value indices but underperformed the quality index.

The perception that performance and sustainable investing are mutually exclusive was shown to be incorrect with these highly ranked ERIG funds consistently outperforming the benchmark, while also scoring highly amongst peers for their Responsible Investment (RI) capabilities.

Interestingly, the top ten performing First Quartile Australian Equities funds included RI strategies offered by ‘mainstream’ fund managers, ETFs, and those managers who solely invest through a RI lens.

“One particular first quartile fund manager’s sustainable equity fund outperformed the benchmark by 7.5%pa over three years, while the ETFs in the top ten also outperformed by 2%pa,” says Angela Ashton, ERIG Index founder.

“Fund managers that are not necessarily known for their ‘sustainable’ or ‘ESG’ products have scored similarly well in terms of performance and Responsible Investment scores, highlighting that we must look beyond the name and instead at the actual intention and actions of a fund manager. Not just to avoid greenwashing, but to find gems as well.”

“We are beginning to see the rise of Responsible Investment being woven into the standard practice of fund managers and this essentially results in best practice. Best practice sees long term sustainability and long term returns delivered simultaneously.”

Results

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[1] The ERIG scoring method is unique – looking at what a fund manager’s investment process is doing with respect to Responsible Investment (RI) rather than just looking at RI scores for companies. For managed funds, this top-down approach is more robust than the ‘bottom-up’ approaches used by many of the traditional RI scoring methodologies. Funds are rated based on seven RI capabilities, but this is also combined into an easy-to-understand ‘Quartile’ ranking. The top 25% of all funds in an asset class receive the First Quartile ranking, while the next 25% receive a Second Quartile ranking, and so on. Quartile rankings are not performance based, solely reflecting the breadth and quality of the RI processes the fund manager is using.

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