- New report from CFA Society of the UK urges investment professionals to manage client expectations and understanding of the risks and provides six key considerations for investment professionals
- Report shows how negative rates have worsened the global risk-reward trade-off
- It lays out three macro-economic scenarios for the next 18 months, identifies a range of market distortions driven by negative rates and reviews their expected impact on asset classes
- Investors face an increased danger of assuming inappropriate risks in the hunt for yield
CFA Society of the UK (CFA UK) today releases a new report exploring the impact of negative rates and the risks to investors.
Its publication follows concerns that the economic downturn due to further COVID-19 restrictions could trigger an historically unprecedented shift to negative rates in the UK. The Bank of England recently confirmed interest rates remain unchanged at 0.1%, having dropped in March from 0.25% in February. However, rates have tumbled globally as well as in the UK this year and negative and ultra-low rates – which were once thought to be transitory – look set to prevail for several years.
CFA UK finds that negative rates could have a deeper, broader and longer-lasting impact than before, due to the COVID-19 pandemic.
The new paper looks at three macro-economic scenarios that could develop from the current global context over the next eighteen months, focusing on the impact on assets, banks and pension schemes. The scenario identified as most likely is a slow but gradual “U-Shaped” economic recovery, in which short rates do not quite go negative in the US and UK.
The main finding of the paper is that, under the U-Shaped macro-economic scenario, the risk-reward trade-off has worsened, with lower prospective returns and more market distortions.
Market distortions identified in the report
With rates now so low, a number of market distortions are identified in the report as increasingly evident, including:
- G7 government bonds now appear to offer asymmetric risks and reduced diversification benefits to multi-asset portfolios, as yields approach a lower bound.
- In fixed income, carry trades are shifting capital from low yield financial centres (such as Japan, the Eurozone, Scandinavia, Switzerland) and concentrating in those with higher policy rates, for example the US, Australia and Emerging Markets, stressing FX funding markets.
- In equities, growth company valuations climb ever higher. We are also seeing a rise of speculative IPOs and special purpose acquisition companies (SPACs), which raise money from public equity in order to acquire unspecified private companies, and involve the risk of shareholder not knowing what the acquisition will be ahead of the transaction taking place.
- Corporate balance sheets are deteriorating with credit ratings migrating downwards; banks meanwhile struggle to remain profitable as net interest margins are squeezed and loan growth slows.
- In real estate, a distortion in real estate valuations, which has seen yields in many cases fall to historic lows, may begin to reverse if the prospect of economic recovery fades, tenants default or weak companies remain on life support, thereby storing up more problems for real estate markets down the line.
- There is an increased appetite for alternative investments, which typically offer higher returns but much less liquidity and transparency. Risk also varies significantly within this category, due to the enormous range of alternatives available.
While CFA UK identified various risks to investors, the paper does note some benefits, most notably the incentives that a low cost of capital creates for both borrowers and investees. Low funding rates also make government and corporate capital-intensive investment proposals more attractive. This could be particularly positive for the long-term infrastructure projects that are needed to meet carbon emission reduction targets and broader social and environmental goals.
Recommendations for investment professionals
Based on the findings, CFA UK is urging investment professionals to carefully manage their clients’ expectations and understanding of the current investment climate, and clearly highlight the risks of investing against the current backdrop of negative rates.
The report outlines six questions that investment professionals should bear in mind when constructing portfolios or advising clients (detailed below), which cover return expectations, risk analysis, portfolio liquidity and professional conduct. CFA UK expects these six questions will remain important as long as negative rates persist and probably outlive the 18-month time-frame of the economic forecasts in the report. They are as follows:
- Return expectations: are my client’s return expectations reasonable given the low expected future returns offered on many assets?
- Contributions: in light of the above, are my client’s current contributions (or savings) sufficient to meet their objectives?
- Risk levels: conversely, are some clients assuming too much risk in order to hunt for yield in a low return world? For example, are risks now higher than they were for traditional portfolios with high government bond weightings?
- Risk Management: when considering risk, what are the limitations of my risk model(s) in relation to the assets in which the portfolio is invested? Do they, for example, rely completely on historic correlation, volatility and drawdown data which may not hold in the future? How have I addressed those limitations, even if only qualitatively?
- Portfolio (il)liquidity: how long would it take to liquidate the client’s entire portfolio? How much would it cost do so? How do those figures compare with the past and is the level of exposure to illiquid assets still appropriate for the client’s needs?
- Conduct: as the hunt for yield continues, are my client advice and investment decisions accounting equally as much for the risk characteristics of a product/asset as its return potential? Are my fees likely to look reasonable in a lower return world?
Says Andy Burton, Professionalism Advisor at CFA UK: “The central conclusion of the paper, that the risk-reward trade-off has worsened, is worrying for both the investment profession and end-investors. It is critical that investment professionals communicate openly with clients, perhaps more than ever before. A good way of laying out the risks and giving comprehensive guidance is through focused use of Investment Policy Statements (IPS), which we could see become more important as investors increasingly shift towards alternative investments.”
Says Will Goodhart, chief executive of CFA UK: “Keeping negative rates low for a long time was designed to address the risk of falling into a depression, rather than a recession. However, risk doesn’t just go away; it arises elsewhere. We’re currently seeing more liquidity risk, leverage and credit risk in portfolios as people chase returns. Investment professionals need to be aware of this, monitor it and communicate the risks properly to clients. The current landscape also raises serious questions about how we ensure the large unadvised market of investors can still get the information they need about negative rates and the risks associated with them. This is something for the investment profession to consider, whether that be through the development of robo-advice, or other methods.”
READ THE NEGATIVE RATES REPORT
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Notes to editors:
This report was compiled by CFA UK’s Negative Rates Working Group. Its members are CFA charterholders working across a number of different UK asset managers.
For further information or to request an interview, please contact Ogilvy: CFASocietyUK@ogilvy.com
About CFA Society of the UK
CFA Society of the UK is part of the worldwide network of member societies of CFA Institute, the global association of investment professionals. CFA Society of the UK represents the interests of 11,000 investment professionals in the UK, through advocacy, education, events and professional development. It aims to promote the highest standards of ethics, education, and professional excellence in the UK investment profession, for the ultimate benefit of society.