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The Contrarian Trade


… the only smart thing a long-term investor can do is to buy the assets which have been sold because of their higher volatilities. This is obviously equities.” – Charles Gave

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In Sum

If investors believe that the strategies that have worked well in the recent past are those to turn to for repeat performances, then monies will continue flow to REITs, Dividends, and Emerging Market and High-yield bonds among other ‘Alternatives’.

If, however, investors believe that buying what and when others are selling, then public equities may be the contrarian trade for the coming years.

Details

Institutional investors, it would seem, intend on continuing a move away from the historical volatility of equities towards alternative investments.

Anticipated Alternatives Allocations

US Public Pension Plans asset mix

US Corporate Pension Plan asset mix

While asset re-allocations are more measured than the headlines indicate, the move from public equities to alternatives continues. Fixed income’s dwindling return and equities’ volatility are causing institutional investors to lean more heavily than ever on alternative investments.

A State Street survey of 100 institutional investors indicates 56 percent intent to move from public equities to private markets like private real estate, private equity and infrastructure (plus hedge funds and commodities). In doing so, State Street commented that institutions are exhibiting a herd mentality and that institutional investors of all stripes are pursuing similar strategies.

The fund flows to Alternatives continue despite red-flag warnings from voices like Leo de Bever from Alberta’s AIMCo. Prices for some alternatives assets have already crept up to what some fear are unsustainable levels. “To be honest, there isn’t much to invest in …

Individual investors too, continue to shun stocks. McKinsey quarterly indicates that Alternatives are moving quickly into the retail investment portfolio (US mutual funds) space with US investors favouring Gold and Real estate funds while European investors favour multi-strategy funds. (Multi-strategy funds could include absolute return, energy, managed futures, long-short, market neutral, leveraged &/or inverse among other more exotic funds).

JP Morgan US mutual fund flows 2007 - 2012

The Contrarian Trade

I skate to where the puck is going to be, not where it’s been.” – Wayne Gretzky

While fund flows data from Blackrock (iShares.ca) show that investors moved to Dividends and High-yield bonds (in the search for yield) as well as Emerging markets earlier in 2012, a momentum switch back to equities started in the fourth quarter 2012. “We expect this momentum to continue in equities, particularly emerging markets, to carry over in 2013 while fixed income flows slow.” The tide may already be turning.

Alliance Bernstein points out that while equities have underperformed bonds and active management has struggled to beat passive management … performance tends to be mean-reverting. Further, based on the equity risk premium (the extra return over risk-free ie. safe bonds), equities look cheap.

Charles Gave comments that financial theory uses price volatility to measure risk. But prices are artificial because of government / Central Bank intervention. That makes volatility artificial and meaningless. Volatility no longer indicates asset risk. He concludes … in a world of suppressed volatility, the only smart thing a long-term investor can do is buy the assets which have been sold because of their higher volatilities. This is obviously equities.”

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A contrarian trade will always take a position that is opposed to the majority – the herd. And, because the contrarian trade buys what is out-of-favour (or sells what is in demand), it is, by definition most uncomfortable on day 1. It only becomes obvious five years hence.

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Next time? More Risk Management.
Doug Cronk CFA is Manager, Investments for a Canadian Pension Plan
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