Thursday, July 28th, 2016
Nearly a year ago, we reviewed commentary and predictions by one of Australia’s top asset consultancy groups – JANA. Their commentary made for sobering reading because it suggested that most asset classes would return either neutral or unattractive returns (ie, low risk adjusted returns) in 2015/16. Recently, Super Ratings reported that the average balanced fund achieved a return of 2.5%.
As 2015/16 unfolded, many of JANA’s return predictions occurred as volatility became elevated. However, some asset classes produced surprising returns and it is worth understanding these to determine if they may re-occur this year.
The most notable surprise came from bond markets, which also led to revaluations on a range of income-yielding unlisted investments. When bonds rally, it usually leads to an actuarial revaluation of unlisted infrastructure assets because they are priced off the bond yield and lower discount rates.
JANA’s commentary last year included the following table that summarised their forecasts succinctly.
Figure 1. JANA’s Asset Allocation tilts in 2015/16
When reviewing investment outcomes for 2015/16, we believe that the balanced funds that did better than average are likely to have had a high allocation to unlisted or direct investments. The best performing asset classes in 2015/16 were both listed and direct (unlisted) property, infrastructure assets and bonds. Indeed it was the performance of bond portfolios that have confounded most experts and forecasters. Even the Australian bond market performed in line with international bond markets and produced an adequate return of 5% to 6%.
One of the most extraordinary returns was posted by international bond portfolios, and in particular, the Japanese bond market. Remarkably, a balanced Japanese bond portfolio (up to ten years in duration) produced no net yield. However, the unrelenting use of QE had the effect that Japanese bond prices rallied throughout the year and produced a total return of 5% in Yen. Remember that as yields fall, bond prices rise and generate a capital gain. This financial year, even more gains have occurred as the Japanese twenty year bond has moved to a negative yield.
Our conclusion is that balanced funds have two parts to their returns – positive returning assets (driven by lower bond yields) and negative returning growth assets.
The positive returning assets of property (direct and listed), infrastructure and bonds probably generated about 4% return to the whole portfolio. The flat or negative returns were from local and overseas equities and hedge funds. These assets probably returned negative 1% over the year. The end result was the 2.5% average.
Looking forward, it seems likely that bond yields may well fall further in coming months as the effects of Brexit, European political and financial disruption plus the US Presidential election take place.
However, we caution against an expectation that lower bond yields and its consequences for asset pricing are sustainable. We believe that gains in the short term from bonds may well be snuffed out in the second half of the year. Equity prices will be driven by growth rather than PER expansion. We also perceive that growing and sustainable yield (properly acquired based on value and risk) will continue to dominate investment returns in 2016/17.