CCI’s investment philosophy is motivated by several insights:
- Cash and fixed-income’s risk-adjusted diversification: On the basis of return targets of CPI plus 3-4% pa and extensive empirical mean-variance optimisation analysis, we believe Australian savers’ asset-allocation decisions have historically resulted in them taking on unnecessarily high exposures to equities, including listed Australian and global equities, unlisted commercial property equities, and private equity. At the same time, savers have historically had insufficiently high portfolio weights to cash securities, floating-rate notes, and fixed-rate bonds, which have offered relatively attractive risk-adjusted returns. We are, therefore, motivated to liberate superior and aligned cash and fixed-income opportunities for multi-asset-class savers. To quantify these arguments we run simple portfolio optimisations across 5 asset-classes: US equities plus dividends, Australian equities plus dividends; Australian government bonds; cash; and Australian corporate FRNs using data since 1988 to examine the historically mean-variance efficient allocations. The crude model takes a target return between CPI + 3% and CPI + 5% and then determines the asset weights that allow the investor to obtain that return over this 27 year period while minimising portfolio risk. The results are highlighted in the table below. If you were seeking returns of CPI plus ~4% over the last few decades (second last row of table), your optimal asset allocations with perfect hindsight were US equities (4%), Australian equities (sub 1%), Australian FRNs (71%), and Australian government bonds (25%) with no investment in cash. If you were more aggressive and wanted CPI plus 5% pa (final row of table), your mean-variance efficient portfolio raised its weight to government bonds (60%) and US equities (12%), while reducing its exposure to FRNs (27%). This analysis is for indicative purposes only.
- Cash is a powerful inflation hedge: We believe that with a central bank that has a formal “inflation-targeting” mandate (as documented under the Statement on the Conduct of Monetary Policy), Australian cash securities and floating-rate notes have delivered attractive “real” or inflation-adjusted returns. Specifically, the RBA cash rate has had a high 73% correlation with core inflation since 1990, which is what one would expect. The RBA cash rate plus 1% per annum has yielded strong real, inflation-adjusted returns of approximately 3.5% per annum since 1990.
- Long-term interest rate duration is a major source of risk: We believe that there is a role in diversified portfolios for active credit strategies with little interest rate/duration risk. Duration is the source of the vast majority of fixed-income volatility and the risk of capital loss (see chart below). We can consider historical probabilities of loss across asset-classes by quantifying the monthly returns delivered by the All Ordinaries Accumulation Index, the AusBond Credit Floating Rate Note Index, which represents investment grade credit beta, and the AusBond Composite Bond Index, which covers fixed-rate bonds and interest rate duration beta. The results are interesting (see table). Over the last 16 years the likelihood of realising a negative monthly return in stocks was 38% even after accounting for dividends. The probability of a negative month in fixed-rate bonds was also reasonably high at around 27%. Yet in FRNs, which strip out interest rate risk, only 2.9% of the 204 months between 1999 and 2015 were negative.
- Inefficient asset-classes: We believe that there are inherent unexploited inefficiencies in the Australian cash and fixed-income markets due to: (1) weak economic incentives in the form of very low fees encouraging very passive, hold-to-maturity investment styles and a paucity of active investment management (and top human talent), which means asset pricing is not as efficient as it should be; and (2) opaque price discovery as a function of the fact that wholesale bonds settled through the ASX-owned Austraclear do not require prices to be publicly disclosed, which means that rapid information flows are thwarted. This again opens up opportunities for nimble active managers to exploit these discrepancies.
- Short-term duration/curve exploitation/positioning: While long-term duration is impossible to predict, we believe that the interest rate-related financial markets do present systematically attractive short-term opportunities to exploit pricing inefficiencies around major macroeconomic events, such as RBA cash rate decisions, and the release of tier-one economic data.
- Active asset-allocation between cash and credit: We believe that active managers can add considerable value by dynamically adjusting portfolios for relative value opportunities between cash and FRNs, which is borne out by our portfolios’ highly contrarian asset-allocation across cash and FRNs and the superior returns that this has furnished, as noted above.
- World-class analytical skill-sets enable rigorous asset pricing (ie, valuation skills): We believe that the fusion of top human talent on a cross asset-class basis with a commitment to comprehensive quantitative asset pricing (valuation) on both a bottom-up and top-down basis—burnished by more traditional qualitative due diligence—will enable us to consistently identify and exploit mispriced assets that can deliver true “alpha”, or risk-adjusted excess total returns, over and above the passive yield provided by those assets.