By Ian Lance
Alice laughed. ‘There’s no use trying,’ she said ‘one can’t believe impossible things.’ ‘I daresay you haven’t had much practice,’ said the Queen. ‘When I was your age, I always did it for half-an-hour a day. Why, sometimes I’ve believed as many as six impossible things before breakfast!’
– Through the Looking Glass by Lewis Carroll
While being a trustee or adviser to a pension fund, family office or endowment has never been easy, the challenges being faced now must feel completely impossible for a number of reasons.
Firstly, most funds need to generate returns of at least 6-8% in order to fund their current expenditure or future liabilities at a reasonable cost and nearly all asset classes are priced to produce returns considerably below this level.
Elsewhere, bonds offer low volatility and high probability of capital protection but are priced for poor returns and will be disastrous in an inflationary environment. In addition, central bankers’ experiments with quantitative easing mean inflation risks cannot be ruled out and conventional bonds will offer little protection in such an outcome.
While equities offer some inflation protection, a decade of equity market volatility and drawdown means funds are loath to take on additional risk in order to reach these return targets.
The issue for many funds, therefore, is how to increase the potential returns on their portfolio, how to generate a stable investment income, and how to provide an element of inflation protection but without exposure to a large degree of volatility and drawdown risk.
We believe that a low volatility equity income strategy is one possible solution to this problem and in particular, we would argue that combining equity income with a quality strategy is the key to reducing volatility and drawdown (smoothly growing the income distribution over time and protecting and growing funds).
The challenge for fund managers is to find stocks with these characteristics at low starting valuations and not to fall in to the trap of overpaying for perceived stability.
We believe that equities are priced for 4-5% p.a. real returns at best but in the event of a mean reversion in valuation and earnings this would be closer to 0-1% real. Given the associated volatility of equities, this may not be enough of a premium over bonds to cause some funds to favour them.
In addition, the majority of this equity return is likely to come from dividend yield rather than valuation shift (given the above average starting point) or growth (given elevated corporate profit margins and poor economic outlook). This is another reason why investors should be considering an equity income strategy as part of their portfolio today.
Ian Lance is co-head of the income team at RWC
Comments