Why choosing to play safe can sometimes blow up in your face
Today’s bull markets are fundamentally different from those of the recent past. The dotcom equity boom of the late Nineties and the commercial property bubble 10 years later were fuelled by over-optimism and heightened risk appetite. The currently elevated levels of both shares and real estate are, by contrast, a consequence of risk aversion.
Stung by the financial crisis and two savage bear markets within eight years of each other, investors today are principally interested in capital preservation and income. This has driven them into perceived safe havens which, ironically, may be exposing them to the risks they are trying to avoid. In the equity market this has fuelled the boom in large capitalisation technology shares, while in property it has driven the prices of prime buildings to excessive levels.
The safety-first mentality explains why today’s bull markets are so grudging. The top of the cycle is characterised by over-exuberance but high prices today are accompanied by an over-arching sense of anxiety and pessimism. This may well extend the cycle, because it has left more money on the sidelines, but it cannot defy gravity indefinitely. Investors need to ask themselves whether it has ever been more risky to play safe.
The flight to safety in the property market is clearly seen in the divergence of the yields available on prime and secondary buildings. From the late Eighties until the financial crisis, the premium income earned by investors for higher tenant default risk was unchanged, perhaps half a percentage point on average. Over the past 10 years this spread has widened and now it stands at maybe two percentage points, four times as much.
The reason for this is that investors remain wary of the perceived risk of secondary properties. They still yield more than they did in 2007 in many cases. By contrast, prime property has seen a flood of safe haven investment and, consequently, the rewards for investors are pitifully low. Prime is considered lower risk and, therefore, worth paying up for in a risk-averse world. The reality is rather different, however. Whether you are investing in the UK or continental Europe, the volatility of returns for top-end offices in London, Berlin and Paris is actually greater than for these respective real estate markets as a whole.
One reason for this is a misunderstanding about the source of returns. In property, these are largely driven by income, which is stable, and not capital gains, which are volatile. Over the past 50 years in the UK, the property market has seen a number of booms and busts but throughout this period the income paid has been remarkably predictable. Capital values, however, overshoot in both directions with about 80pc of current returns explainable by last year’s performance. Property is a momentum and sentiment-driven market.
The same psychological biases can distort the equity market. Ever since the financial crisis, investors have sought to minimise volatility and avoid losses. They have done this by favouring investments that they perceived to offer reliable and predictable growth and/or income. This explains the attraction of equity income funds and, more recently, the FAANG technology stocks.
The rise and rise of these parts of the stock market has been exaggerated by some structural shifts in today’s financial markets too. For example, the apparently unstoppable growth in passive investment vehicles, including ETFS, has seen money increasingly fall on the biggest pile. Rising prices attract yet more money as a stock’s weighting in an index increases, driving the price yet higher.
The arrival of low-volatility investment strategies has added fuel to the fire. Because technology stocks have attracted a steady stream of investment from risk-averse investors, they have seen their volatility decrease below that of traditional safe stocks. Another virtuous circle has been created for these flavour-of-the-month investments.
The self-perpetuating nature of these trends means that they can persist for much longer than expected. And they can intensify in their later stages as sceptics can no longer bear the pain of missing out and belatedly join the party.
What investors should do at this late stage of the cycle, however, is twofold. First, they should progressively de-risk their portfolios as the bull extends and ages. Second, they should swim against the recent tide from active investment to passive. The time to blindly go with the market flow is when assets are cheap. In a rising market it doesn’t matter which individual investments you own.
In a sideways-moving or falling market, it is vitally important that you distinguish between the winners and losers. This is true whether you are investing in shares, bonds or buildings. An analysis of the Frankfurt office market a few years ago gave the average return as 2.4pc but the difference between the best and worst performing individual building that made up that average was 33 percentage points. It was the difference between a fall of nearly 20pc and a rise of more than 10pc.
Exactly the same dispersion happens in the stock market. When we looked at a recent period of sideways movement in the FTSE All Share index we found that, over a three-year period, 29pc of shares rose by more than 75pc. By definition these outsize gains were offset by other shares that fell significantly.
The conclusion for both equity and property investors is that as the market cycle matures it is more important than ever to look for value in the less fashionable parts of the market that risk-averse momentum investors are overlooking.
When the price is right, investors may find that taking on risk is the safest thing they can do.
Tom Stevenson is an investment director at Fidelity International. The views expressed are his own. He tweets at @ tomstevenson63