The diversification dilemma
Achim Backhaus, who heads the fund-of-funds and Multi-Asset business at Hauck & Aufhaeuser, warns about naïve diversification in fixed income products.
The buzzword of the financial year so far is the Great Rotation. Many analysts, investors and fund managers expect a massive flow out of bond products into equities, although recent fund flow data fail to back up this hypothesis.
Backhaus, working at the Frankfurt-based private bank, disagrees with the consensus.
“The Great Rotation remains a non-event,” he says. “Regulatory pressure guarantees that government bonds are a safe asset class that many institutions ought to hold. If there are flows into equities, they stem from commodity outflows, or even gold. Investors rotate out of different asset classes more than is widely perceived.”
His scepticism about the Great Rotation thesis notwithstanding, the German fund selector seeks returns in stocks with “good years for equity markets” as few investors have yet decided to delve into the asset class.
“In bond markets investors have climbed up the risk ladder. If the most conservative fixed income investor pours money into subordinated debt or bonds from emerging markets, I would expect that flows into equities could be next.”
Backhaus can thus foresee a scenario, in which corporate bonds sell off as equities rally, even though these asset classes were closely correlated in the past. This could be driven by the liquidity that the fixed income asset class has attracted in the past five years. Lipper data shows that investors have taken big steps up the risk ladder in bonds.
At the end of February €580bn were invested in corporate bond, high yield and emerging market bond funds in Europe, compared with just €189bn before the financial crisis in 2007. This tripling comes at a time when yield spreads have fallen, even though Europe remains in a tough economic environment. But yield spreads should be a function of economic stress.
The fixed income sphere thus offers little value, apart from its importance for portfolio construction. Safe government bonds might serve as an anchor to portfolios going forward, but Backhaus thinks low yields will at some point put pressure on the return profile of insurance companies and other financial intermediaries.
“No investor buys into an asset with negative yields over 20 years. There is pressure by regulators, but at some point pension funds and insurers have to look beyond fixed income.”
Backhaus reckons that diversifying into riskier debt securities might not be that beneficial in future. “Be careful about diversification,”he warns. “Investors have to diversify intelligently across risk factors.” That might mean looking beyond simple asset class diversification, and focusing on what might happen if a risk event, such as the reversal of fund flows, occurs.
“Emerging market debt [EMD], for instance, could have a similar risk as equities during a risk-off period because of the massive flows we have seen recently. Thus EMD might offer little true diversification. When the herd moves into a specific direction, investors will suffer if they did not buy at attractive valuations. When money flows out, the selling pressure will lead to disappointment.”
Liquidity remains a key issue for Backhaus, even five years after the initial outbreak of market turmoil in money markets amid a freeze of liquidity.
One of the edges of a private bank such as Hauck & Aufhaeuser, with its 217-year-long history, he adds, is that the portfolio manager does not need to buy into every trend in the market. One way to illustrate that: the bank is highly convicted to the survival of the Euro Area, at a time when many of its competitors were selling their portfolios with high allocations to gold, the safest equities and a lot of angst on behalf of their investors.
But Backhaus is sure that the European Central Bank, its offices just around the corner from the Frankfurt office of Hauck & Aufhaeuser, is committed to the single currency.
“Investors today willingly buy into corporate bonds in Emerging Markets that yield less than Italian government bonds with their implied ‘Draghi-Put’,” he notes.