In an imaginary world, being a hedge fund investor called Seth Klarman with a fund called Baupost would be fun, based purely on unusual names, but also on the longevity of his loyal followers. In the past week, this ‘renowned’ (there are a few after all) investor noted that the concept of risk has vanished and the market is no longer acting as a pricing, or more correctly, valuation, mechanism.
Inevitably such high-profile managers will make these comments when their performance lags, but there is no doubt that risk has been sedated by ever-increasing debt and the intervention of central banks.
In this light, it’s worth considering the two very different risks that dominate most investors’ minds, outside of news flow. Firstly, the risk in the real capital value of a portfolio (or required rate of return) and secondly, the volatility in markets. By all accounts Baupost is skewed to volatility management, holding a large 25-30 per cent in cash, but thereby reducing its returns and incurring some loss of faith from the long-standing asset owners.
In parallel, another widely distributed communication ‘Musings on Markets’ has a new post, ‘the price of risk’. Using Aswath Damodaran’s consistent formulaic approach, the S&P 500 is currently assessed as 12 per cent overvalued. Here, the risks accounted for are in the risk-free rate and the assumed risk premium. Such discussions are unlikely to go down well with a client.
As the source of return is essentially capital gain and/or income, these are easy for all to embrace. They have readily understandable foundations, be that the development in a corporate strategy towards higher earnings or cash flow generation towards higher dividend payments. Fixed income is similar, with gains coming from movement in rates and spreads, while income is the coupon payment.
What will confound a client is if rates rise. Current preferred equities based on long-term disruptive growth may be valued lower than today even if their profit and loss outlook remain unchanged. The risk may therefore not be some strategic flaw but simply the impact of duration.
The second will be in the required risk premia. As Damodaran points out, risk premia and credit spreads can vary a fair amount. Combine a change in the risk-free rate and higher risk premia and life will be uncomfortable for portfolios anchored in long-duration stocks.
Even so, not all these are in the same boat. Infrastructure stocks are typically long-duration given the structured nature of their cash flows. Yet for some a rise in rates, presumably associated with an element of inflationary pressure, can result in upward adjustment to cash flows.
Asset allocation articles nominate risks for 2021. These typically are fixated on observable issues such as the success of the vaccine rollout, consumer spending or premature central bank tightening. These are easy to fill-up a discussion with an investor, but the mechanics of markets are much harder. Why are valuations unscientific, why do asset prices change even if their cash flows are as expected?
We have essentially given up on bonds for uncorrelated low-volatility returns. It has left a void in asset allocation that alternative debt strategies do not fill, even if they have their own other merits. Instead of bond duration strategies, the growth story is now loaded with equity duration and therefore much higher volatility. Low-volatility equity funds can be expensive if based purely on large cash weights that can be achieved cost-free in a portfolio. On the other hand, stable-return low-volatility alternative and debt strategies should potentially be favoured compared to those with higher volatility, even if their returns are higher.