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There is no free lunch

July 2016

Antares Fixed Income

In the current investment environment investors should be wary of chasing unrealistically high return targets in a world awash with central bank intervention and near zero interest rates. This has resulted in a search for yield that has impacted all asset classes, driving valuations to arguably overvalued levels.

In May 2016, Peter Costello, Chairman of the A$120 billion Future Fund, publically stated that the Fund was in negotiations with the Federal Government to lower its long-term return target of inflation plus five per cent. At a

Women in Banking and Finance lunch in Sydney, he said, “Would the government rather us preserve what we’ve made, and reduce the target so that we stay where we are on the risk curve? That is a big issue. Does the government have an appetite for us to chase risk? I don’t think so...Our problem is we have been asked to get a five per cent real return… which is very, very difficult”.

This conundrum now faces the entire investment industry, across all asset classes. The Future Fund, like all investors, is faced with the cold hard truth that in today’s ‘low yield’ world, they can either lower their return target or increase the risk they are prepared to accept.

Risky business

While some investors have adjusted their return expectations or curtailed the risk in their investment portfolios, others have been pushed further out on the risk curve in search of returns. Many investors may now be invested outside of their risk ‘comfort zone’ as they attempt to boost their diminishing returns in the lower yield environment. This has resulted in heightened risks being borne by investors, and in turn has huge consequences for the liquidity and volatility of risk assets.

A volatile combination

Investor behaviour can contribute significantly to liquidity risk in markets, as investors outside their risk comfort zone are prone to cut their losses very quickly. At the same time, traditional liquidity providers such as investment banks have significantly curtailed their market-making activities in response to regulatory constraints. The combination of ‘knee-jerk’ investors and reduced market-making activities has resulted in reduced liquidity, and will continue to produce extreme volatility in most markets, particularly equities and credit.

The risk of reduced liquidity is a real concern for investors, with the spike in illiquidity and market volatility during January and February 2016 a clear warning. Reserve Bank of Australia Governor Glenn Stevens at a conference in New York on 19 April 2016 said, “We don’t know how liquidity will stand up under genuine stressed conditions. This is of increasing importance”.

Not the ‘new norm’

While some are referring to the current environment with its evolving risk-return dynamic and heightened liquidity fragility as the ‘new norm’, Antares believes it is just the latest evolution of a constantly changing market.

And while there is certainly no ‘free lunch’ available to investors, because returns do come with risks, opportunities exist for astute investors who understand the inherent risks. Investors should stay focused on their investment objectives and timeframes, and constantly review and evolve the way they construct their investment portfolios.

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