Focusing On The Horizon

As driving course instructors point out (without a hint of irony) – no one in their right mind would drive forwards by looking only in their rear view mirror. In fact, students are advised to raise their line of vision to the furthest possible point on the horizon. This doesn’t mean ignoring the more immediate risks close to you, peripheral vision takes care of that. But what lengthening your horizon does do is give you the time and flexibility to react to potential changes in conditions ahead, as well as the best possible chance of arriving at your destination safely and promptly.

This metaphor to investing is powerful, even if unoriginal.

Buy high, sell low

Prima facie, preparation, a long-term investment horizon and forward thinking would appear to be elementary building blocks to successful investment. But as the accompanying chart shows – pension funds have steadily increased their exposure to long-term gilts over the past few years as gilt yields have dropped. The more gilt prices have risen, the more capital has been allocated.

Why? First, it’s important to acknowledge that there are other issues at work here apart from long-term investment returns – though this in itself shows the shaky intellectual ground on which the decisions were based. The impact of actuarial reviews and ballooning liabilities as benchmark gilt yields have fallen have pressurised pension funds, at least conceptually, to ‘de-risk’ and to accept that buying more of an asset as its price rises might be a good thing.

With gilt yields now rising substantially off their lows some schemes have started reducing their bond exposure. Some have rotated into equities – five years after the bull market in risk assets started and as its major support, liquidity provided by QE, is being withdrawn. If gilt yields continue to rise as confidence in the economic recovery hardens, we would not be surprised to see schemes continue this sell low, buy high strategy.

Rear view mirror investing

There are several issues worthy of debate in this scenario. First, we believe part of the reason why pension funds have increased their exposure to gilts is due to the lack of genuine alternatives presented to them by mainstream consultants, many of whom lack expertise in the broader universe of non-traditional income generating and growth asset classes such as Absolute Return, Private Equity, Property and Commodities. Inevitably with a narrower set of asset classes, the opportunities for genuine diversification and optimised risk-adjusted profile are limited.

The second point is that any advice based on backward looking analysis is fundamentally flawed. Many mainstream consultants amplify the mistake of rear view mirror asset allocation advice by adopting the same approach with manager selection. At Gatemore we have a very different investment approach. In particular, we distinguish assets by their economic drivers of return and not by simplistic asset class labels – most of which are unhelpful in achieving investors’ aims. Mindful of the cardinal sin of “investing in what you wish you already owned” we look at valuations in a genuinely long-term context.

The benefits of a different approach

Doing the exact opposite of funds in the chart above, we reduced our clients’ exposure to gilts as yields fell. Admittedly it was at times difficult to convince our clients to reduce their allocations to some of their best performing assets. Now however we are in a position to consider purchasing those very same bonds back as yields rise. It is precisely this long-term approach that we believe gives our clients the best possible chance of achieving their goals via the optimal route while avoiding major mishaps.