Andrew Yap

Managed accounts are on track to exceed $400 billion by the end of the decade, with technology and tighter regulation pushing the sector towards stronger, more transparent growth, Andrew Yap, head of portfolio solutions at Zenith says.

“Managed accounts are growing rapidly and becoming a more significant part of the Australian market,” Yap says.

“The most recent figures available suggest around $300 billion in assets sits within this segment, with expectations it will grow north of $400–$450 billion by 2030. That’s a very strong growth trajectory for the sector.”

Yap says technology has made the market more scalable by strengthening risk management practices, particularly with respect to monitoring portfolio exposures, factor and liquidity analysis. Together with deepened asset allocation expertise, the two factors have been vital to the sector’s expansion in a volatile global environment.

“Over the past five years in particular, technology has transformed how managed accounts are constructed. Early models relied on simple spreadsheets that were focused on high level outputs, compared to today where we use institutional-grade systems for cash-flow modelling, stress testing and scenario analysis,” Yap says.

“You can’t assess a portfolio’s durability and probability of achieving targeted objectives without an informed understanding of liquidity, factor exposures and key risks through sophisticated systems. You need to drill into the underlying holdings and understand how a portfolio would behave under stress.

“Our approach is to synthesise what’s happening in the broader market, understand what that means for asset allocation, and identify opportunities that represent our best views and the goals of our clients.

“Technology plays a key role in supporting this process, but importantly, it doesn’t replace it.”

While the sector’s rapid growth has created opportunities, it has also attracted a significant number of new entrants to the market, which Yap says investors need to be sensitive to. At the same time, developments such as ASIC’s focus on fee and performance outcomes and platform oversight have sharpened standards across the sector, which Yap welcomes.

“If managed accounts are a path that someone wants to pursue, they need to be cautious about who they partner with. With that in mind, the onus is on us as providers to help our clients understand what’s happening in the market and why they should feel confident in our approach,” Yap says.

“The regulator’s focus on fund performance, governance and conflicts of interest will hopefully lift standards across the board, which is ultimately positive for investors.”

Yap says increased scrutiny in the sector over the years ahead will separate long-term providers from the more opportunistic players, and identify those positioned to best deliver for Australian investors.

“Longevity matters in this market. Strong governance frameworks and investment infrastructure take years to build,” Yap says.

“Managed accounts are in our DNA. We’ve been operating in this space for more than 10 years, making us one of the first movers in the sector, and we’ve built a very strong platform and framework to support our clients.”

The post Managed accounts to surpass $400 billion by 2030 as technology and regulatory scrutiny reshape the sector appeared first on AdviserVoice.

Andrew Yap

A successful managed account portfolio must balance model outputs with professional judgement and insights, Andrew Yap head of portfolio solutions at Zenith Investment Partners says.

Mr Yap says while quantitative models provide an important input into the portfolio construction process, real-world insights are essential to navigate the uncertainties of the current market environment.

“Models give you the numbers, but they can’t always tell you how markets will behave. Human judgement and insights are what turns data into resilient portfolios that can withstand unexpected shocks, which is especially important in today’s environment,” Mr Yap says.

“Will it be a smooth ride, will we hit a recession, or is a sudden boom around the corner? This is where the experience and expertise of investment professionals make all the difference and can be what turns a good plan on paper into a resilient portfolio that can weather real-world storms.”

Zenith uses deep insights from its internal investment research team and asset allocation experts to apply qualitative insights to refine its customised portfolios to meet a broad range of client objectives.

“Our investment research team is an essential part of the process, as it’s critical that we ask what they are seeing from the coalface. They act as a valuable sounding board for the portfolio construction process to test active views and to aid in the selection of primary and back-up fund managers with confidence,” Mr Yap says.

“A managed account provider with access to contemporary insights can produce a more robust long-term outcome. They will consider current market intelligence including emerging trends, sector specific themes and the team’s high conviction views, which helps keep the chosen portfolios ahead of the curve.”

Mr Yap added that the need for qualitative judgment is even greater in less liquid investments such as private assets, and that the future of portfolio management lies in blending both data and deep professional insights.

“With private assets, we need to explain both the numbers and the story,” Mr Yap says.

“The data is powerful, but it has to be paired with a transparent conversation about the risks, the long-term commitment, and the importance of choosing the right manager.

“The future will be about weaving them together and giving us the confidence to stay calm when markets are shaky and the situation changes.”

Managed accounts have become a mainstream investment offering over the last decade as financial advisers and their clients realise their many benefits, including improved efficiency, scale and cost advantages. Zenith currently manages more than $6 billion in client assets across both customised and public menu managed account portfolios.

The post Quality investment research is the secret ingredient in successful managed account portfolios appeared first on AdviserVoice.

Andrew Yap

Zenith Investment Partners has promoted Andrew Yap to Head of Portfolio Solutions.

In his new role, Mr Yap will help lead Zenith’s Portfolio Solutions team of 12 investment professionals, overseeing the construction and delivery of portfolio solutions for clients. He will report to Damien Hennessy, Investment Director. The appointment comes as Zenith’s Portfolio Solutions business approaches $6 billion in funds under management, reflecting strong client engagement and performance.

Mr Yap has been with Zenith for more than a decade, holding a number of senior positions, including Head of Multi‑Asset & Australian Fixed Income research, before being appointed Deputy Head of Portfolio Solutions in July 2024. Over this time, he has been instrumental in advancing Zenith’s multi‑asset, real return, and Australian fixed income research capabilities, as well as driving innovation in portfolio construction and governance.

With over 20 years’ industry experience spanning research, consulting, financial advice, audit, and management accounting, Mr Yap brings deep technical expertise and a proven track record in delivering strong client outcomes. Prior to joining Zenith, he was Associate Director and Head of Multi‑Asset at Standard & Poor’s Funds Management Research Division and has also held senior roles at PPB Advisory and Pitcher Partners.

Matthew Warren, General Manager & Group Head of Product & Data, said Mr Yap’s appointment reflects both his leadership within the business and his commitment to delivering value for clients.

“Andrew’s deep knowledge of our business, our clients, and the broader investment landscape makes him uniquely placed to lead our Portfolio Solutions team. During his 10 years with Zenith he has consistently demonstrated the ability to unite and inspire teams, add value to our research and portfolio capabilities, and deliver innovative solutions that meet the evolving needs of advisers and investors. His leadership will ensure we continue to deliver exceptional outcomes for clients,” Mr Warren said.

Mr Yap is based in Zenith’s Melbourne office and will lead the recruitment of an additional consulting resource in response to client demand.

The post Zenith announces new appointment to leadership team appeared first on AdviserVoice.

Andrew Yap

Despite continued tightening of monetary policy from central banks’ interest rate hikes, bond portfolios could still generate positive investment returns in the years ahead, says Zenith Investment Partners head of multi-asset and fixed income, Andrew Yap.

Mr Yap says that while such a view may seem counter-intuitive, the performance of bond markets is determined by the market’s anticipation of future rate rises rather than the actions of central banks.

That considered, he believes official cash rates across the US, UK, Europe and Australia are likely nearing the market’s forecast of peak cycle.

“Should inflation surprise on the upside, this may extend the current interest rate hiking cycle. That said, the yield on offer across developed market sovereign bonds is sufficiently high to offer a cushion to offset capital losses on any subsequent bond repricing,” Mr Yap says.

“Retaining an overweight to bonds may translate into outsized returns as central banks loosen policy to stimulate growth. Active management may prove to be rewarding in the years ahead, and managers with a proven track record in interest rate management are positioned to outperform.”

Mr Yap says an unexpected rate hike would result in downward pressure on bond prices.

However, given the recalibration in global cash rates and the subsequent rise in bond yields, he adds that cash rates would have to rise significantly higher than anticipated before the capital losses exceed the income generated from bonds (see table below).

Source: Zenith Investment Partners

“Interest rates in Australia would need to rise a further 0.35 per cent above the market’s implied peak cash rate before the 3.30 per cent yield to maturity is fully offset,” Mr Yap says.

“While such an outcome is not outside the realms of possibility, it’s a lower probability event and as such sovereign bond holders have a reasonable level of insulation against unexpected hikes in the official cash rate.”

Mr Yap says the yield curves of 10-year Treasury bonds issued in the US, UK, Europe, and Australia reflect the market’s forecast of where cash rates will be in the future, taking into consideration near-term expectations, inflation and real long-term growth rates (see graph below).

Source: Zenith Investment Partners

Based on the 10-year Treasury bond yield curves, Mr Yap concludes that the market is pricing in further rate hikes for each of the above geographies to combat inflation.

“In the case of the US, markets are anticipating that the Fed will raise interest rates to 4.98 per cent by May 2023, up from its current level of 4.88 per cent (being the midpoint of its 4.75 to 5.00 percent),” he says.

“Should subsequent increases in this rate remain within this range, it’s unlikely that the 10-year sovereign bond yields will significantly shift.”

The post Bond portfolios may create positive returns despite rising interest rates appeared first on AdviserVoice.

Damien Hennessy

Markets appear to have trust in central banks’ ability to ‘get the job done’ but there are risks to this view, according to Damien Hennessy, head of asset allocation with Zenith Investment Partners.

“Market-implied inflation expectations remain well-anchored and have actually declined this year, indicating the market is confident the central banks will act and be successful in their inflation fight. Markets also believe the central banks are willing to risk recession. If the central banks ‘pivot’ too soon, markets may begin to lose that confidence,” he said.

In the current environment, he questions how achievable the current ‘CPI plus’ and ‘Cash plus’ investment portfolio objectives are from a medium to longer-term perspective.

“Over the past year, the global inflation spike has weighed on market sentiment, contributing to a broad-based sell-off across many asset classes, with only a small number generating positive returns. In such an indiscriminate market, there’s been limited scope for the funds in the real return universe to deliver positive returns.

“The market declines have been so widespread that even those markets perceived to be safe havens in rising inflation scenarios, such as gold and inflation-linked bonds, have struggled, with the latter impacted by the jump in real bond yields. For example, Australian inflation-linked bonds have lost more than 13 per cent this year, despite their inflation protection qualities. Real bond yields are the bedrock for all asset class valuations, hence the focus on some unlisted assets that have yet to show meaningful adjustments,” Hennessy said.

Andrew Yap, head of multi-asset and Australian fixed income, added that as interest rates have increased, this has seen the risk-free rate go higher which has had a roll-on impact for capital market assumptions and asset allocation more broadly.

“With Australia experiencing its highest inflation levels since the early 1990s, advisers face a common problem – how to maintain the purchasing power of client portfolios and deliver a level of return consistent with investment objectives.

“Real return funds in particular have had a challenging time of late – impacted by the challenge of managing a fund to a set of ‘CPI plus’ objectives when inflation is running well above trend,” Yap said.

The real return category is a group of strategies that target ‘CPI plus’ outcomes and therefore seek to deliver long-term returns that outpace inflation and deliver consistent capital growth. Yap said targeting real outcomes is a client-friendly concept, however the recent environment has highlighted the challenge of building truly ‘inflation-proof’ portfolios.

“The breadth of asset classes with direct linkage to rising inflation is limited to a few markets, such as inflation-linked bonds, commodities and some equities sectors such as energy, precious metals and consumer staples. But some of these are now being impacted by the demand-destruction resulting from the increase in interest rates designed to alleviate inflation.

“Therefore, building a portfolio that could outperform in a rising inflation environment is likely to be challenging, particularly where managers seek to retain portfolio diversification to enhance the capital preservation qualities of their portfolios.

“The recent inflation spike has highlighted that managers in the real return sector rely on the indirect inflation-hedging properties of traditional asset classes to deliver real long-term returns, as opposed to building portfolios with direct inflation linkage.

“While this isn’t surprising, it reinforces the importance of investing over the longer term, the role of real return managers in managing portfolio exposures in terms of allocating capital across different asset classes, and the inclusion of a broad set of strategies to generate attractive real returns,” Yap said.

The post Portfolio return objectives challenged by inflation appeared first on AdviserVoice.

Andrew Yap

With Australia experiencing its highest inflation levels since the early 1990s, advisers face a common problem – how to maintain the purchasing power of client portfolios and deliver a level of return consistent with investment objectives.

Over the past year, the global inflation spike has weighed on market sentiment, contributing to a broad-based sell-off across many asset classes, with only a small number generating positive returns. In such an indiscriminate market, there’s been limited scope for our real return universe to deliver positive returns, with the median manager returning -3.86% for the 12 months ending 31 August 2022.

The market declines have been so widespread that even those markets perceived to be safe havens in rising inflation scenarios, such as gold and inflation-linked bonds, have struggled, with the latter impacted by the widening of nominal bond yields. For example, Australian inflation-linked bonds retraced by approximately -9.4% over the year, which means that despite their inflation protection qualities, returns looked very similar to other bond markets.

The real return category is a group of strategies that target CPI plus outcomes and therefore seek to deliver long-term returns that outpace inflation and deliver consistent capital growth. Targeting real outcomes is a ‘client friendly’ concept, however the recent environment has highlighted the challenge of building truly ‘inflation proof’ portfolios.

The breadth of asset classes with direct linkage to rising inflation is limited to a few markets, such as inflation-linked bonds, commodities and some equity sectors (eg. energies, precious metals, consumer staples). Therefore, building a portfolio that could outperform in a rising inflation environment is likely to be challenging, particularly where managers seek to retain portfolio diversification to enhance the capital preservation qualities of their portfolios.

The recent inflation spike has highlighted that managers in the real return sector rely on the indirect inflation hedging properties of traditional asset classes to deliver real long-term returns, as opposed to building portfolios with direct inflation linkage. While this isn’t surprising, it reinforces the importance of investing over the longer term, the role of real return managers in managing portfolio exposures in terms of allocating capital across different asset classes, and the inclusion of a broad set of strategies to generate attractive real returns.

Equities – the cornerstone of real return investing

Across our real return category, we’ve observed that the exposure to equity beta has been the largest contributor to total return. This observation is unsurprising and is also the case across more traditional strategic asset allocation (SAA) centric diversified strategies.

The sensitivity to movements in equity markets varies based on a manager’s view on relative value, exposure to lowly correlated asset classes, and the use of capital preservation strategies (eg. tail hedging, allocating to safe haven assets).

In theory, equities should provide an effective hedge against inflation as equity holders own a claim on the future earnings of a company, which should be able to pass on increased costs over the long run. For example, rising wage and input costs should be able to be passed onto the end consumer, assuming that the product isn’t perfectly substitutable or subject to high demand elasticity.

Further, several equity sectors tend to directly benefit from high inflation, such as energy companies, whose earnings are highly correlated to movements in oil and automotive fuel prices. Other sectors where demand is relatively inelastic and lowly correlated to the economic cycle, such as agriculture, consumer staples and precious metals, also tend to perform well.

However, the relationship between equity returns and inflation is unstable, reflecting the impact of other macroeconomic factors on equity valuations. In addition, the equity market tends to respond to changes in inflation expectations well in advance of ‘actual inflation’ being recognised in the official data (noting that such releases are lagged post quarter end).

In rising inflation environments, the relationship has been unstable and tended to weaken and revert to close to zero. As detailed earlier, changes in inflation expectations are likely to have a stronger effect on equity valuations, correlating more closely with changes in inflation expectations versus ‘actual’ higher inflation.

In terms of equity valuations, they tend to suffer when inflation expectations are rising, as investors price in the impact of higher discount rates on future expected corporate earnings and the premium required to hold equity risk increases, in a higher inflationary environment.

Equity risk: a long-term contributor to total return

Over the long term, the equities allocation in real return portfolios is expected to deliver positive real returns and provide a foundation upon which CPI plus objectives are achieved. An exposure to equities alone will not, however, be sufficient for managers to achieve these objectives. To illustrate this, the following chart plots the return of the Australian equity market over rolling five-year periods, with the blue line representing a CPI plus 5% p.a. objective, for the past 30 years.

As shown above, there have been few instances post GFC where Australian equities achieved CPI plus 5% over a rolling 5-year period. What can be concluded therefore, is that performance success is likely to be strongly aligned to a manager’s market timing skills and their preparedness to position their portfolios ahead of market inflection points. Arguably, this is an area where real return managers should outperform relative to their SAA-counterparts who have less flexibility to alter their portfolio mix in anticipation of changing market dynamics.

The role of fixed income

Fixed income remains a key allocation across the real return universe, both as a source of return and a diversifier of equity risk. Inflation is widely regarded as being harmful to fixed income, as it erodes the capital value of bonds and reduces the purchasing power of fixed coupon. Therefore, the inflation beta of fixed income is structurally negative, albeit the strength of the relationship changes over the investment cycle.

Nominal bonds are susceptible to rising inflation which is a challenge for real return managers seeking to deliver CPI plus outcomes. Over the long term, we’ve observed bonds deliver positive real returns, however, through periods of high inflation, real yields can be negative.

Real return managers have the flexibility to structure their fixed income portfolios to navigate periods of rising inflation and nominal bond yields. This can be achieved via a combination of active asset allocation (eg. reducing the allocation to fixed income) or through more stratified approaches such as running duration overlays, allocating to external managers who share similar views on the environment and/or preferring shorter dated or floating rate securities.

Generally, the real return universe has been proficient in managing fixed income exposures with a tendency over the past year to be short or underweight relative to longer-term positioning. The following chart illustrates the average fixed income allocation across the real return universe.

From the above chart, it’s evident that managers have been active in altering their fixed income exposures, most notably increasing their allocations as the yields on 10-year bonds rise. We view this move as considered, noting that a rise in portfolio yield introduces defensive qualities which can aid with capital preservation.

Cash Plus versus CPI Plus

We believe Cash Plus objectives to be more suitable for real return and diversified strategies, given cash is an investable concept and represents a starting point for allocating risk across portfolios. Furthermore, defining a return objective linked to an un-investable benchmark has the potential to create expectations that portfolio returns are linked to inflation changes.

Cash isn’t a perfect benchmark and can produce negative real returns in high inflation environments or stagflationary regimes where central banks prioritise full employment and economic growth over inflation. However, we view it as a superior benchmark against which manager performance can be observed, particularly in environments where inflationary pressures are either sustained or meaningful.

By Andrew Yap, Head of Australian Fixed Income and Multi-Asset Research

The post CPI target-based investing – it’s the real thing! appeared first on AdviserVoice.

Andrew Yap

With the sell-off in domestic fixed interest markets over the past seven months, the sea of red ink was a painful reminder of the risks of investing in bonds. The -11% drawdown in the Bloomberg AusBond Composite Bond index from its peak in October 2021 has only been matched by the 1994 calamity where bonds lost approximately 8% over a 10-month period.

Following the rout and if history serves a guide, we believe that the worst of the pain might be already behind us. With the steepening of yield curves, there may be an opportunity to build some attractive yields into client portfolios.

Background

Since the Global Financial Crisis (GFC), bond yields have structurally declined across developed markets. Investors required less compensation for assuming inflation risk, and other market forces such as QE programs, the search for yield, ageing demographics, poor productivity and various effects of globalisation created a downward pressure on bond yields.

In Australia, 10-Year Government Bond yields reached their lowest point in the third quarter of 2020 at approximately 0.8%, as they tracked broader movements in global bond markets.

At the same time, the Federal Government embarked on a large issuance program through COVID-19, with the Commonwealth Government Securities (CGS) growing to approximately $A840 billion (including Treasury Indexed Bonds) by the end of March 2022.

The growth outstripped the other sectors in the domestic bond market, as the Government component increased in relative importance, contributing to a significant duration lengthening of the Bloomberg AusBond Composite Index. The following chart highlights the relationship between the modified duration and yield-to-maturity (YTM) of the benchmark.

The confluence of the benchmark’s duration risk almost doubling and the YTM compressing from above 6% to below 1% created an inevitable scenario for investors, where the asset class had lost its yield cushion and were fully exposed to future inflation shocks and interest rate rises.

The magnification of risk is captured in the below chart, where we illustrate how many 0.25% interest rate hikes were required. This is based on the prevailing modified duration of the benchmark (and assuming a parallel shift in the yield curve), before the YTM of the Bloomberg AusBond Composite Index was exceeded and capital losses were borne by investors. Note, the below analysis does not seek to capture the tendency of yields to incorporate forward-looking information and increase prior to actual interest rate rises.

The yield cushion of the AFI benchmark had declined over the past decade to a point where in late 2020, the benchmark couldn’t absorb a 25-basis point interest rate hike (or change in expectations), before offsetting the prevailing YTM of the benchmark and triggering capital losses. Hence, we can’t really be surprised that we subsequently experienced such a large drawdown once the inflationary environment changed and yields increased.

The road ahead for bonds

 The recent sell-off in Government Bonds has resulted in the Australian 10-year Government Bond yield rising from approximately 1.68% at the start of 2022 to 3.55% in early May. The inflection point was the March quarter CPI release, which showed that year-on-year inflation was running at 5.1% (or 3.7% on a trimmed mean basis).

Against this backdrop, the market priced in a cash rate of 2.65% by December 2022, increasing to 3.23% in May 2023. If the market is correct in terms of its forecasts, the RBA has some heavy lifting to do over the next six months, while trying to navigate a finely balanced economy.

Moving through the hiking cycle and the impact on bond prices

If the market is not overly hawkish in terms of its expectations for interest rate hikes and we move into a sustained hiking cycle, the potential impact on domestic bond markets is likely to be driven by market sentiment. This would in turn highlight the RBA’s effectiveness in providing forward guidance on the direction of future policy.

What we do know is that when the RBA implements interest rate rises, Government Bond curves tend to flatten, or in other words, long-end bond yields rise less than the actual rate increases. Intuitively, the market looks through the hiking cycle and focuses on the impact of the rate rises on economic growth, inflation, wages and the implications for future cash rate settings.

In the following chart, we plot the movements in the 10-year Government Bond yield through RBA hiking periods for the period beginning January 1988 to the end of April 2022.

Over the period, 10-year Government Bond yields were relatively immune from changes in the cash rate, particularly since the 2000s. Moreover, yield curves flattened in each of the hiking periods as the market typically assessed the longer-term, macroeconomic impact of such interest rate rises. 

The pace and magnitude of the RBA’s approach to returning monetary policy to a neutral setting will ultimately determine the level and path of bond yields. Typically, hiking cycles impact front end rates, while global factors (most notably movements in US Treasuries) influence longer dated bond yields. Long bond yields have typically peaked when the central banks reach neutral and often before the eventual peak in the cash rate.

At Zenith, we continue to use nominal GDP trend growth as an anchor for bond yields, which currently sits at around 4%. Since the GFC, bond yields have traded below nominal GDP growth, being influenced by the same forces that have driven down shorter-term rates detailed earlier.

The following chart highlights the close relationship between 10-year Government Bond yields and nominal GDP growth, defined as trailing 10-year average GDP growth.

A normalisation of bond markets could potentially see bond yields closer to nominal GDP growth rates, which is around 4%. However, the path of interest rates won’t be linear and should provide attractive opportunities for active management.

As we move further into the RBA’s hiking cycle, we believe that most of the pain is behind us and future rate hikes should have a moderate impact on bond portfolios. assuming the RBA is effective in providing forward guidance. Importantly, with the recent spike in bond yields, managers have been able to build valuable yield buffers into their portfolios, which should provide some positive real returns over the medium term and protection in the event of further inflation spikes.

By Andrew Yap, Head of Multi-Asset and Australian Fixed Interest

The post The great fixed income rout – were we really blindsided?   appeared first on AdviserVoice.

Andrew Yap

As the world adjusts to COVID and vaccination rates continue to rise, there’s much hope that life will return to some form of normal in the near to medium term. Consistent with this view, it’s likely that global economies ‘reboot’ supported by an easing in restrictions on movement, a rise in consumption (particularly within service orientated sectors such as tourism), a clearing in bottlenecks across logistic channels, and improved labour market conditions.

Amidst this backdrop, there’s been ongoing rhetoric regarding the prospects of a re-emergence in inflation, and ultimately the impact this may have on the forward prospects for asset classes and at a time where many are trading at rich valuations (relative to historical averages). This matter is further complicated by factors such as unintended outcomes from central authorities unwinding Quantitative Easing (QE) and governments removing fiscal stimulus from the economy.

In past years, we’ve written extensively about the theoretical merit of real return funds (RRfs), noting that their flexible investment mandates provide them with greater optionality (relative to their SAA-counterparts) to adjust asset class exposures in response to changing market conditions. However, little consideration has previously been given to their inflation protection qualities, noting that many have investment objectives linked to the Consumer Price Index (CPI).

Understanding the concept of inflation

At a high level, inflation refers to the movement in the price of goods & services consumed by households. The most well-known indicator of inflation is the Consumer Price Index (CPI). This measure, also known as Headline Inflation, is calculated by the Australian Bureau of Statistics (ABS) and is released to market on a quarterly basis.

Movements in the headline inflation rate can be relatively volatile when assessed from one quarter to another. Cognisant of this, the ABS also release alternative measures of inflation to provide further information on how Australia’s underlying inflation is tracking. The most common amongst these are the Trimmed Mean and Weighted Median measures, albeit an exclusion-based CPI measure is also calculated, one that removes highly volatile categories such as fuel.

While a detailed understanding on the calculation methodology supporting each of these measures is beyond the scope of this article, it’s worth noting that the quarterly movement between these measures can be quite meaningful when assessed from one release to another.

Transitory versus structural inflation

An informed assessment of inflation necessitates more than just a view on its rate of change, but also its persistence. Regarding the latter, economists tend to focus on the trajectory and strength of inflation. Where there’s a short-sharp rise in inflation, this is often referred to as transitory. Conversely, where there’s a sustained upward trend, this is regarded as structural.

Transitory inflation tends to be driven by demand related factors and these dissipate once supply catches up to meet with the imbalances. Conversely, structural inflation is impacted by supply side factors which can include events such as wars, droughts, floods, bottlenecks across supply chains, etc.

Managers of RRf’s spend considerable time attempting to frame Australia’s inflationary backdrop as either transitory or structural, and for the purposes of providing insight into the potential response that the Reserve Bank of Australia (RBA) may take. Historically, the RBA has tightened monetary policy (i.e. increase the official cash rate) where trimmed mean inflation has established a persistent upward trajectory above 2.5% as shown in the chart below. These responses have tended to be linked to the emergence of more sustained as opposed to transitory inflation.

In such an environment, we believe there’s scope for RRfs to produce competitive performance outcomes, notwithstanding the negative impact that structural inflation may have on the performance of asset classes such as bonds. This reflects the following:

• Time: as pricing pressures tend to be more persistent (rather than episodic), managers have greater time to adjust portfolio positioning, and
• Imbedded flexibility: relative to their SAA-counterparts, there’s greater opportunity for RRf managers to alter portfolio positioning to benefit from the prevailing macro environment.

The above environment contrasts with one in which there’s a short-sharp spike in inflation (i.e. transitory) where it’s believed that RRfs are more likely to lag their CPI target in the near term. This reflects the lagged nature of the ABS’ quarterly inflation data (i.e. the data for June 2020 was released in late July), which makes it difficult for managers to adjust portfolio positioning in response to stronger than anticipated price movements. Effectively, managers are unable to retrospectively adjust asset class exposures and lean their portfolios toward those market segments that benefit from such price movements. And for those managers adopting headline inflation for benchmarking purposes, the extent of underperformance is likely to be more profound.

Inflation and asset class opportunities

To provide an indication on how various mainstream asset classes may perform where inflation is on the rise, we’ve produced the following table.

The extent to which managers of RRfs implement conviction-based views and alter portfolio exposures in response to a re-emergence of inflation will depend on several factors including their fundamental views, market timing capability and mandate constraints.

We believe that the performance of RRfs will be most heavily influenced by market timing. This will be particularly pertinent in an environment where asset class valuations appear to be stretched and inflationary pressures are building.

An issue however is that few RRf managers have demonstrated an ability to consistently add value through market timing activities. Furthermore, the level of value -add has dissipated since the advent of QE, which has acted to lower market volatility, making it more challenging to implement strategies such as tactical and dynamic asset allocation.

Cognisant of this challenge, there’s been a growing focus by managers on strategy selection and sector structuring. Regarding the latter, this has become particularly evident with respect to fixed interest and equity exposures. In terms of fixed interest, we’ve observed growing exposures to inflation-linked bonds and floating rate credit. In terms of equities, strategies have been focused on value-orientated sectors and those likely to benefit from a re-emergence from inflation (ie. hotels, tourism).

What may the future hold?

Determining how to position a multi-asset portfolio through these unknown market conditions will no doubt be challenging and translate into a broad set of performance outcomes.

If inflation subsequently proves to be more persistent and the RBA was confident inflation was in the upper end of the targeted range, the next course of action would be an unwinding of the RBA’s bond purchasing program (also known as ‘tapering’). Tapering is likely to have an impact on funding rates, most notably across longer-dated maturities (i.e. 10 year rates) which are likely to rise and place pressure on equity valuations and translate to meaningful losses on bond portfolios. This was the experience of the US in the latter part of 2013 when it first announced its intention to taper, which also led to a significant rise in market volatility. Equities managed to perform reasonably well after some initial volatility.

The key conclusion to reach here is that the actions of the RBA and governments will have an impact on funding rates, valuation multiples, market volatility and ultimately the direction of asset classes. As such, investors seeking exposure to RRfs should expect portfolio outcomes to vary meaningfully across the sector.

By Andrew Yap, Head of Multi-Asset and Australian Fixed Income Research

The post The durability of real return funds in an inflationary environment appeared first on AdviserVoice.

Andrew Yap

The Australian Fixed Interest sector was not immune from the effects of the COVID-19 crisis with the median manager in Zenith Investment Partners’ Australian Fixed Interest (AFI) category producing a net return of 5.46%, for the 12 months to 30 April 2020 trailing  the Bloomberg AusBond Composite Index (0+ Years) by 0.96%

According to Zenith’s latest sector report, for the second consecutive year, absolute returns were strong across the AFI Bonds category as the Reserve Bank of Australia lowered the official cash rate from 1.50% p.a. to 0.25% and yields on Australian government securities rallied from approximately 1.70% p.a. to 0.87% p.a. (as at 30 April 2020). Credit-orientated strategies were adversely impacted by the crisis, resulting in the median manager in the Corporate Debt category returning -0.36%.

Andrew Yap, Head of Multi-Asset and Australian Fixed Income at Zenith, said it was not surprising that most of the underperformance in the sector was experienced during the March 2020 quarter, as the full effects of the COVID-19 downturn were absorbed by the market and managers navigated a period of extreme interest rate volatility and unprecedented monetary policy support.

According to Yap, through the extremes of the COVID-19 market sell off, liquidity across fixed income markets was significantly impaired. Consequently, many managers increased their bid-offer spreads to account for the costs of transacting their portfolios.

“We observed a lack of uniformity when it came to adjusting sell spreads,” said Yap.

“The lack of liquidity in domestic and global fixed income markets through the COVID-19 crisis was a major challenge for fund managers, as they sought to balance rapidly declining bond prices, mark-to-mark losses and fund outflows, with highly attractive buying opportunities.

“During these periods, the ability of investors to buy and sell bonds is reduced, resulting in higher transaction costs or bid-offer spreads. Investors and their advisers have needed to be extra-vigilant to these moves in considering portfolio changes.”

Zenith’s research found that the AFI – Corporate Debt universe experienced the largest increase in buy/sell spreads, rapidly moving from 0.09% to 0.88%, with the highest being 1.72%. The AFI – Bonds universe experienced more modest increases with the average increasing from 0.09% to 0.58%.

However, despite the extremes of COVID-19, Yap believes that there remain opportunities for active managers to outperform. This is likely to be most evident for those managers with a demonstrated track record in yield-curve and sector rotation strategies.

“That said, asset class returns are likely to be constrained, reflecting the unintended consequences of significant fiscal stimulus packages and quantitative easing.”

A copy of the condensed sector report can be found here.

The post AFI managers challenged by COVID-19 but opportunities for outperformance remain appeared first on AdviserVoice.

Andrew Yap

Amidst an investment environment where asset class returns are forecast to be lower with greater volatility, Zenith Investment Partners has observed a greater willingness of Multi-Asset managers to incorporate non-traditional asset classes within their strategic asset allocation.

In the past, this has included unlisted assets such as private equity and debt. However more recently, Managers are adding Real Assets to the mix believing they have unique characteristics that can help to improve portfolio efficiency.

Zenith, in its Multi-Asset – Diversified sector report looks at this growing trend and finds that while Real Assets can be a welcome addition to a diversified portfolio, exposures are nuanced and not without risk.

Real Assets are attractive to managers for a number of reasons,” said Andrew Yap, Head of Multi-Asset and Australian Fixed Income at Zenith.

“They can generate strong, stable cash flows that are linked to inflation. Additionally, their earnings tend to be less cyclical than shares, offering some protection when equity markets sell-off. That said, an assessment of Real Assets requires a specialist skill set in recognition of their structural complexity and intensive nature of physical asset management.”

In Zenith’s opinion, Fund Managers need to ensure they have the right people to manage these types of investments. Furthermore, capital market assumptions need to evolve as do optimisation techniques to ensure the appropriate funding and blending of such exposures.

The post A growing trend to add Real Assets to a Fund’s targeted asset mix appeared first on AdviserVoice.