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The passive fund behemoth refuses to consider possibility that inflation will remain high
A debate is currently raging in the financial press about balanced funds, both passive and active, and I have been an active participant. With respect to passive balanced funds, the focus has been on Vanguard, perhaps because its LifeStrategy fund range is the largest in terms of size: excluding the LifeStrategy 100% Equities fund that I do not consider to be a balanced fund, total fund range AUM is GBP30 billion. However, Blackrock, L&G and HSBC also offer ranges of passive balanced funds that are large and have been subject to the same forces as Vanguard's, namely the lowest risk funds over the past two years posting sizeable losses and the highest risk funds doing ok. The reason? Bonds.
The latest article on the debate, published on Tuesday, was written by Citywire's Caroline Hug and titled Vanguard: Give low-risk LifeStrategy funds 2-3 years to claw back 2022 loss. The article presented Vanguard's defence of its poor performing low risk balanced funds, and used various comments of mine to present an opposing view.
The balanced fund concept, one that is invested in equities and bonds in specific ('balanced') proportions, is arguably the fund industry's flagship retirement product. Indeed, it should perhaps be thought of as the industry's key product, given that retirement savings account for the lion's share of total. There is a lot riding on this.
At the heart of the debate is the question of whether inflation will stay high for the next decade or two. If it does, bonds will continue to perform worse than equities and low risk balanced funds will continue to post bigger losses than high risk funds. I think it will. Vanguard doesn't.
For the record, I am generally a fan of balanced funds, particularly passive balanced funds given their low costs. Most of the time they work just fine, as had been the case, at least until recently, for the best part of 40 years. But during periods of persistently high inflation that occur every few decades, they will struggle. I have been warning about the inevitability of such a period for a few years now.
Below are various parts of the article, together with my thoughts on them.
"The struggle for Vanguard’s LifeStrategy low-risk funds epitomised the plight of the 60/40 asset allocation model, but the firm believes this year has been a ‘complete outlier’, although admitting it may take a while to recover 2022 losses."
It is true that, in the context of the last 40 years, this year has been a 'complete outlier'. In the context of the last 100, it hasn't been.
"However, faster-than-expected rate hikes in a bid to curb soaring inflation, the repercussions of the Ukraine war, and the disastrous UK mini-Budget in September have put pressure on these balanced portfolios, as the close correlation between bonds and equities left nowhere to hide."
The pressure on balanced funds began in mid-2020 when bond yields began to rise. They then came under further pressure when inflation began to rise sharply in early 2021. In other words, they were under pressure long before the invasion of Ukraine in February this year. As for the close correlation, it is true that bonds and equities both fell, but this does not mean that they both fell by the same in percentage terms. Indeed, equities have held up much better than bonds the last two years, so would have been a good hiding place.
"Vanguard multi-asset product specialist Mohneet Dhir described this year as a ‘complete outlier’ for these portfolios, describing the recovery from Covid and Russia’s invasion of Ukraine as exogenous events, which caused inflation to soar."
My view is that Covid and Russia's invasion of Ukraine were catalysts, not causes, of the soaring inflation. The causes related to overly loose monetary and fiscal policy. It is possible that inflation is showing signs of decelerating, and indeed may fall a bit in the next couple of years. However, my belief is that governments and central banks will be forced to prioritise growth over inflation in the years ahead: monetary and fiscal policy will remain too loose and inflation high, as happened after the 1969 recession.
"‘These models still invest in high-quality investment-grade bonds,’ Dhir added. ‘A large part of the performance for both LifeStrategy 20% and 40% Equity has been due to the positive correlation between bonds and equities. The central bank’s aggressive interest rate hikes drove negative bond performance this year, and ultimately tipped correlation into positive territory'...In her defence of the low-risk model, Dhir noted that the correlation between bonds and equities has historically proved to be short-lived, using 2017, when the correlation turned positive for a brief period, as an example. 'Between 1995 to today, the correlation between equities and bonds has only been positive 13% of the time,’ Dhir said. ‘Each of those times, positive correlation has been short-lived.’"
Whether two things are positively or negatively correlated depends on the time frame over which they are measured - the temporal resolution. Demand for ice cream and hot chocolate will be negatively correlated on a short-term - monthly/seasonal - basis but positively correlated over the long term. It is true that based on short-term returns, equities and bonds are most of the time, as Vanguard suggests, negatively correlated. However, short-term returns should not matter to investors, long-term returns should. On the basis of long-term returns, equities and bonds are very much positively correlated. Indeed, it is the positive longer term correlation between bonds and equities that drove the fabulous returns for Vanguard's funds until recently!
Also, measuring correlation since 1995 as Vanguard has done won't work as the period does not capture years in which inflation is persistently high as was the case from 1965 to 1981.
"One of its fiercest critics, ex-Seneca IM CIO Peter Elston, suggested Vanguard may be in denial."
Again, my point here was that to understand how balanced funds might perform going forward, one must analyse the behaviour of bonds and equities over the very long term, not just since 1995. Looking at the behaviour of each over anything up to 40 years will fail to capture how they perform when inflation is persistently high.
"Elston is not as convinced, however. In his blog, he suggests investors calculate bond volatility based on 30-year returns, rather than focusing on short-term volatility."
Based on 30 year real returns, bond volatility is 70% higher than that of equities. This is counterintuitive but reflects the fact that companies - equities - can do things to mitigate the effects of high inflation such as increase prices, cut expenditure, shift production etc. Bonds cannot.
"Elston believes that if inflation does persist, as history suggests it might, a positive correlation could be the new norm."
Over time frames that matter to investors - i.e. longer ones - bonds and equities are always positively correlated.
"Dhir admits this period was a bond bear market, but she does not expect fixed income to go through such a prolonged period of suffering this time, highlighting the average bear market usually only lasts for around a year."
From 1940 to 1981, US bonds returned -67% in real terms. That's a 41 year bear market, a tad longer than "around a year". Perhaps Vanguard needs to broaden its historical perspective.
"While she appreciates investors might have some concerns, Dhir expects central banks’ aggressive rate policy to filter through into the economy and ease inflationary pressures, which will be good news for bonds."
This is the nub of the issue. Vanguard's LifeStrategy funds will be just fine if we return to a disinflationary environment. My view is that we won't, whether because governments will be forced to prioritise growth over inflation, flawed econometric models, cognitive bias, second order effects (accelerating wages), the need to deflate debt, heightened geopolitical risk, the reversal of globalisation/developing economy labour no longer being cheap, or the need to start allocating significant resources to clearing up the waste we have pouring into our environment the last 200 years.
"Vanguard’s Capital Markets model predicts inflation will reduce to 6.3% in 2023.
This leaves it optimistic on the outlook for the LifeStrategy 20% and 40% equity funds, forecasting 2023 returns of 5.7% and 6.3% for the strategies respectively. On this forecast, it expects the funds to return to their December 2021 valuations within two to three years. ‘This is in line with the recovery periods we’ve seen historically for multi-asset portfolios, following similar periods of simultaneous stock and bond declines over the past 100 years.’ Based on these numbers, Vanguard expects a recovery period of between 30-40 months for LifeStrategy 20% investors, and 24-31 months for LifeStrategy 40% investors."
I take issue with Vanguard's assertion that their expectation for their funds' recovery is 'in line with...similar periods of simultaneous stock and bond declines over the past 100 years'. Based on the 1970s which was the last period of simultaneous declines, worse is to come.
"At the end of 2021, the percentage of negative-yielding assets in the global bond index was 16.5%. This year, as of the end of September, that percentage has more than halved to 7.8%.
Therefore, every time investors buy a new bond when rebalancing their portfolio, they buy at a higher yield and coupon rate, which has a positive compounding effect in the long term, Dhir notes."
It seems that Ms Dhir may be looking at nominal not real returns. Nominal returns are meaningless - you can only put real milk and bread on the table with real returns not nominal ones. It is true that if yields have gone up, investors will be buying bonds at higher yields when rebalancing, but if inflation has also gone up as it may well have done if yields have gone up, the compounding effect in real terms could be negative, not positive.
"‘We know it’s tempting to change allocation or switch into a higher risk portfolio in a year like this, but the reality is that the performance we’ve had this year is just a reflection of everything that has happened,’ she said. Although Dhir is positive that investors will recover in the long term, the impact of the past year has hit pensioners the hardest, who might not be able to further invest in Vanguard’s LifeStrategies to recuperate their losses."
If it is not clear, I do think that in the short term balanced funds could do ok. It is the longer term, the next 20 or so years, that I worry about.
‘"Any adviser who put their clients into [high bond portfolios], whether gilts, treasuries, bunds or JGBs (Japan government bonds), should be praying that their public liability insurance has been kept up to date,’ Elston warned."
Given where real interest rates and inflation were five years ago, it was obvious that bonds were in a massive bubble which would inevitably burst. All that was needed to pop the bubble was a catalyst or two. Passive balanced funds were a great option for retirees for much of the last 40 years, but that does not mean that they were not a lazy option.
The views expressed in this communication are those of Peter Elston at the time of writing and are subject to change without notice. They do not constitute investment advice and whilst all reasonable efforts have been used to ensure the accuracy of the information contained in this communication, the reliability, completeness or accuracy of the content cannot be guaranteed. This communication provides information for professional use only and should not be relied upon by retail investors as the sole basis for investment.
© Chimp Investor Ltd