MLC Horizon 3
Conservative Growth Portfolio
MLC Horizon 3
Conservative Growth Portfolio
30 September 2013
About the portfolio
The MLC Horizon 3 Conservative Growth Portfolio aims to grow wealth for a low to moderate level of expected volatility. The portfolio is invested in an approximately equal mix of defensive and growth assets.
The portfolio is designed to be a complete investment portfolio solution. It’s well diversified within asset classes, across asset classes and across investment managers who invest in many companies and securities around the world.
Source: MLC Investment Management
MLC Horizon 3 Conservative Growth Portfolio performance
The chart below shows returns of the portfolio over one, five and ten year periods. All periods have had positive returns to 30 September 2013.
The returns in the above chart are for calendar years and the 2013 period is calendar year to date. That means the 1 year return for 2013 includes the nine months to the end of September.
Source: MLC Investment Management
Contributors to the portfolio’s returns
Key contributors to performance for the quarter and the year are in the following table. Returns are before fees and tax.
For the quarter / For the year- The Australian shares strategy, currently 21% of the portfolio, produced a very strong return of 10.6%. Market sentiment was supported by a clear federal election result, better economic news from China, the decision by the Reserve Bank of Australia to again reduce official interest rates in early August and a solid profit reporting season.
- Global share markets delivered a strong return over the quarter, despite suffering bouts of weakness as expectations for monetary policy, particularly in the US, dominated sentiment. The portfolio currently invests 17% in global shares (unhedged) which delivered a return of 7.3% over the quarter.
- The portfolio currently invests 48% in the bond strategy which produced a positive return of 1.1% over the quarter. Bond markets seesawed in recent months due to rising interest rates and changing sentiment over US monetary policy and political events in Syria and Egypt. The decision of the US Federal Reserve to not start winding back its quantitative easing programme led to a fall in bond yields in September which was positive for returns.
- The portfolio’s return for the year was strong.
- The return from global shares (unhedged) of 32.5% was the strongest contributor to the portfolio’s return for the year. Over the past year the Australian dollar’s decline has meant that unhedged global shares have significantly outperformed hedged global shares. This contrasts with the previous few years, when our strong dollar meant unhedged global shares significantly underperformed hedged.
- The Australian shares strategy finished the year with a strong return of 25.5%. The last quarter was the highest return for the Australian share market since 2009.
- The fixed income strategy produced a positive return of 2.9% over the year despite fairly weak returns in many sectors of the bond market.
Detractors from the portfolio’s returns
The chart below shows returns for each of the asset classes over different time periods. All asset classes made a positive contribution to the portfolio over all periods shown in the chart.
Source: MLC Investment Management
Our assessment of market conditions
Policy makers are maintaining conditions that support asset prices by suppressing market interest rates. Their aim is to offset the debt burden through increases in asset values and, hopefully, trigger economic growth. Asset prices have risen partly on that hope, but also because central banks are almost forcing investors into riskier assets (like shares) by cutting cash rates and pushing bond yields down. Riskier assets become more attractive as the returns of safer assets decline and their risk levels increase. While this makes riskier assets look comparatively cheap for the time being, the higher prices go the less they are supported by fundamentals. Sustaining the share market rally ultimately relies on economic fundamentals improving.
Tapering of Quantitative Easing is pivotal
The September quarter saw a return to the strong returns from share markets for most of the past year. This followed the “taper-tantrum” of the June quarter. After the US Federal Reserve’s (the Fed’s) surprise failure to taper Quantitative Easing (QE) in September, shares rallied and bond yields declined, and emerging markets in particular recovered strongly.
It’s unclear whether investors have now become more comfortable with the impact of a gradual QE taper, or whether there will be renewed jitters when tapering talk starts. Whatever the answer to this, we can’t forget the share market volatility in the June quarter which hinted at the vulnerability that occurs when assets are purchased because they look cheap compared with government bonds which look very expensive.
The Fed is trying to walk a fine line. In MLC’s language, they do not want to see continuation of a high returning Extended Quantitative Easing (EQE) scenario because it results in excessive risk taking and potentially puts the US back onto an unstable path. They will be much more comfortable with a ‘muddle-through’ scenario with modestly higher share prices, which constitutes a stable adjustment path. Looking forward, there are a number of risks, including the shenanigans over the debt ceiling, a change of Fed chairman and most importantly, tapering has not gone away: the commencement and pace of tapering will be pivotal for markets.
Tentative signs of economic growth
To understand what the future might hold, we need to consider the ways in which policy makers’ actions might or might not translate into higher growth. We also have to consider whether it might lead to increased inflation, rather than real economic growth.
While growth is still under pressure in most developed markets, the private sector is showing signs of life in some parts of the developed global economy, especially the US. The US housing sector and employment seem to be gaining momentum. Europe, too, is showing very early signs of recovery, but is far behind the US. Each country in the eurozone has a different level of debt to manage, but they are shackled to a single currency. Those with high debt levels are limited in their ability to use currency devaluation to reduce the value of their debt. This may hold back a recovery in the region.
Globally, the manufacturing sector is starting to expand. And if the improvements in the US continue, it’s possible US consumers’ and businesses’ tendencies will move from reducing debt to increasing borrowing. In our scenarios approach to setting asset allocation, the possibility of US credit growth resuming sooner than expected is covered in our ‘early re-leveraging’ scenario. This scenario would help increase trade in countries that rely on exports, like China and other emerging markets. A pick-up in Europe or Japan would also add to export growth in emerging markets.
Inflation is a watch point
It can be argued that it’s folly to ‘fight the Fed’ and that monetary conditions will remain loose, driving risk and asset prices higher. However, this becomes more uncertain as QE is gradually withdrawn. And there is potential for heightened instability if an extreme policy stance is reversed. This presents a conundrum: the probability of both a highly positive and a highly negative scenario may be rising. In this process, inflation remains a watch point.
Today’s experimental monetary policy settings could lead to rising inflation: if the supply of something increases massively its price falls, so if a single country ‘prints money’, its exchange rate falls. And if there is collective printing, all currencies are devalued through inflation. While the Fed has flagged it may reduce quantitative easing if the economy continues to improve, the potential impact of further quantitative easing on asset prices is still important. Conditions may turn adverse to growth in the US, and the Bank of Japan and the Bank of England have not been as open as the Fed. With no roadmap for the withdrawal of policy stimulus, the inflation risks are much bigger than the market currently appreciates.
Portfolio positioning
Key to our investment process is our unique Investment Futures Framework (the new name for our ‘scenarios framework’). In an unpredictable world, the Framework helps us comprehensively assess what the future might hold. By taking into account the many scenarios that could unfold – positive and negative - we gain continuing insight into return potential, future risks, and opportunities for diversification.
The information from the Framework gives us a deep understanding of how risks and return opportunities change over time for both individual assets and total portfolios. We can then determine the asset allocations that will help achieve the portfolio’s objective with the required level of risk control, and adjust the portfolio if necessary. We’ll generally reduce exposure to assets if we believe their high risk isn’t matched by a high return. We prefer exposures with limited downside risk compared to upside potential.
The most challenging environments for our approach occur when prices for a broad range of assets rise faster than their fundamentals. We faced this “dilemma of high prices” in the first three quarters of the 2013 financial year and there were signs of it re-emerging in the September quarter. While growth asset prices rise, their return potential reduces and risk increases, and this means there are fewer asset classes that provide diversification. With traditional sources of diversification compromised, we have increased exposure to alternative assets and strategies.
While these trends suggest a more defensive positioning, there remains the real possibility of continued strong returns if the extended quantitative easing scenario again becomes dominant.
The following table summarises the main positions we’ve taken in the portfolio.
Position / Impact on performance / Why we have the positionMaintained exposure to growth assets / This position has performed well as growth assets have been very strong and the portfolio has a high exposure to growth assets. Despite this, the portfolio’s returns may lag peers due to our focus on risk management and broad diversification. / It’s possible for global growth to accelerate if the policies implemented by major central banks are successful and feed through to real economic growth. Some economic indicators currently suggest that growth might accelerate in the near term. If the increase in economic activity is sustained it is possible that we could transition into a mild-inflationary resolution or early re-leveraging scenario. In these scenarios, growth assets should perform strongly.
Another scenario that would be positive for growth assets is extended quantitative easing. This scenario may re-emerge due to weak economic data. If this happens, the market would push growth assets higher in anticipation of further monetary stimulus.
Reduced exposure to interest rate risk by reducing duration of our bond strategy / Has limited the negative impact on returns of rising bond yields over recent months. / In an inflation shock scenario – possibly driven by expectations of inflation – nominal bonds would perform poorly and are at risk of negative returns. Despite low yields, we’ve maintained some inflation-linked bond exposure because, unlike nominal bonds, inflation linked-bond returns increase with rises in inflation.
Reduced exposure to global government bonds / This position has reduced the negative returns from the bond strategy, as yields on global government bonds have risen in recent months. / Government bonds, a traditional source of diversification, still have lower yields than fair value, although their yields have risen in the last quarter. While bond yields could decline further (and prices rise), the extent of this is limited compared to the potential for prices to fall and yields to rise. As a result, we’ve continued to reduce the portfolio’s exposure to interest rate risk in global government bonds.
Reduced exposure to the Australian dollar / The portfolio’s large exposure to unhedged global assets contributed to returns over the year as the AUD fell. / Although the Australian dollar has declined, it has not fallen far enough to completely offset the diversification benefit we get from having some exposure to foreign currency (unhedged assets). This doesn’t mean we expect the AUD to fall further. In two of our scenarios, the AUD is expected to resume rising. However, as we have many scenarios where the AUD is expected to fall (eg China slowdown scenario), and by a greater amount, we prefer foreign currency as a source of diversification that decreases overall risk. This allows greater exposure to higher risk asset classes than we would otherwise have had. If the AUD begins to rise again, it is likely we’ll increase our exposure to unhedged assets to help offset some of the heightened risk from high share prices.
Retained some exposure to interest rate risk / Exposure to interest rate risk in recent months has hurt portfolio returns, as bond yields have risen. This has slightly improved the return potential and deflation protection of bonds. / In a stagnation or deflationary slump scenario, economic growth in the developed world would falter. Maintaining some exposure to interest rate risk (duration) would capture the higher returns from bonds if yields fall.
Stock selection, too, will likely continue to be an important component of return generation.
Changes to the portfolio
We actively manage our portfolios and work constantly to improve them. During the quarter we:
- Increased the allocation to inflation-linked bonds by 0.75% and reduced enhanced cash to take advantage of an attractively priced new government bond issue.
- Increased the allocation to the multi-asset real return strategy by 1.5% and reduced the allocation to the fixed income strategy. The multi-asset real return strategy is managed by three managers, Pyrford, Ruffer and MLC. MLC now manages two multi-asset real return portfolios. One is a “conservative” portfolio that aims to deliver a return of inflation plus 3.5% pa (before deducting fees) over 3 year periods and the other is a “moderate” portfolio that aims to deliver a return of 5% pa over 5 year periods. Both MLC portfolios focus on risk management to limit significant negative returns, have a flexible asset allocation that’s adjusted to manage risk and capture returns as markets change and are diversified across a broad range of assets, strategies and managers.
Changes over the past year are in a separate report, ‘Summary of MLC’s strategy changes in the last 12 months’.
Asset class role and performance
Asset class / Role in portfolio / Contribution to performance (returns are before fees and tax)Australian shares
(21%)
Seven managers / The Australian shares strategy aims to deliver capital growth by using investment managers who invest and diversify across many companies listed in the Australian share market. Results can be volatile over the short term (under three years), but are expected to provide growth over longer terms (more than five years). / The Australian shares strategy posted a return of 10.6% in the quarter and 25.5% in the year. The one year return was 1.2% above the 24.3% return of the market benchmark, the S&P/ASX200 Accumulation Index.
The Australian share market’s return this quarter was the highest for five years and contributed to a very strong one year performance. After recording gains in each month, the market closed at a new all-time high on the second last trading day of the quarter. Uncertainties offshore, such as the US Federal Reserve’s indications that it would taper its quantitative easing program, failed to have an impact. Sentiment in Australia was underpinned by another reduction in interest rates, better than expected data from China and a solid profit reporting period.
Performance in the market this year varied by sector and broader groupings such as cyclicals and defensives. The best performers this quarter were sector and stocks with more “cyclical” characteristics. This was a contrast to recent previous quarters, when sectors and stocks considered “defensive” for their attractive and sustainable dividend yield were preferred investments. The resources-laden Materials index increased 16.3% as several mining companies benefitted from a recovery in spot iron ore prices. The Consumer Discretionary sector was strong (14.6%) as a range of consumer-oriented companies outperformed. Sectors with defensive characteristics underperformed , including Telecommunications (7.4%), Healthcare (5.8%), Consumer Staples (5.2%) and Listed Property Trusts (0.2%).