At Ruffer we spend a lot of our time thinking about how things could go wrong. It’s a function of our design. We have a single investment strategy focused on capital preservation and steady growth, not chasing short term trends. Rather than trying to be absolutely right, we try to avoid the risk of being absolutely wrong. This natural cautiousness leads some to label us ‘permabears’, but our approach has been proven to lead to better long-term performance for our clients.
Protecting our clients’ portfolios from future risks can cost money. This is either explicit, in premium paid, or implicit, in opportunity forgone. So how then has this house of ‘permabears’ returned 8.7% per annum (net of all fees) since inception in 1994? Some would argue this is down to a good choice in our equity exposure, but given that the FTSE All-Share total return index has only returned 7.1% per annum over the same period clearly something else is going on.
Our recent article talked about how market participants evolve specific behaviors that suit the conditions they operate under. In nature, a change in environment causes detriment to those who cannot adapt their behaviour, and opportunity for those who can.
For example, the end of the last Ice Age caused the extinction of animals such as the woolly mammoth who failed to adapt to the changing environment, but the great proliferation of intelligent and flexible animals like the wolf. At Ruffer, we aim to construct portfolios that are robust enough to protect against change, but also flexible enough to profit from it.
This is a simple concept. Protecting the value of your clients’ portfolios through the eye of a crisis allows you to buy assets in the aftermath that greedier investors have been forced to sell.
Forced selling can occur for any number of reasons; what is important is to be prepared for the fact that there are times in the market cycle when investors are forced to sell assets without any reference to their intrinsic value. For example, while Ruffer is well known for having spotted problems in the credit system prior to the financial crisis, what is less well known is that we created special-purpose funds to buy certain assets that were being sold at any price after the event.
It was not that those assets had suddenly become good, but that investors who had been willing holders of assets at twice intrinsic value suddenly became desperate sellers of those very same assets at half their intrinsic value. The difference between the two situations is the availability of capital. Ruffer has in the past, and will in the future, be far happier deploying its clients’ capital into situations where there is a dearth rather than a glut of other investors.
On the other hand, if there is a change in market environment there will also be forced buyers. We also see this as an opportunity. A good example is our allocation to long-dated inflation-linked gilts, which make up around 15% of our portfolios. On the surface these bonds are a poor investment; they currently guarantee a real (i.e. taking inflation into account) loss per annum of around 1.5% a year for the next forty years. This reflects the fact that the market currently believes long-term interest rates to be around 1.5%, and that inflation will stay at 3% over the long-term (leaving you with a minus 1.5% ‘real’ return). But, as the chart below shows, with the price at around £240, if inflation were to rise up to 6%, without any corresponding rise in interest rates, the price of the longest dated inflation-linked gilt would, in theory, multiply around five-fold.
Inflation protection in theory
How the price of the 2068 UK inflation-linked gilt changes at different levels of ‘real yield’
If the real yield changes from -1.7% today to -5.6%, the price of this bond would move from £240 to £1,900 (a c660% increase). A shift of equal magnitude in the opposite direction, to a real yield of +2.4% would result in the price falling to £33 (a c90% fall). This exemplifies how the long-dated index-linked bonds have an asymmetric pay-off, particularly in an environment where higher inflation and low interest rates are likely to play a key role in clearing the real value of debt, currently at unsustainable levels. Source: Bloomberg, July 2018
What’s more, were this hypothetical scenario to become reality we would expect far larger gains. This is for two reasons. First because, as we discussed in our recent article, years of declining interest rates and vanishing inflation have produced a glut of investors who are both complacent of and increasingly sensitive to an increase in inflation. And second, because inflation-linked bonds are in extremely limited supply.
Inflation-linked duration is in very limited supply
Global supply of ‘safe’ real and nominal duration, in trillions of dollar-years
Source: Bloomberg, Ruffer calculations
We expect that even a modest increase in inflation will prove disruptive, and as the green mountain of investors on the right hand side of the above chart are forced to seek the safe harbor of inflation-linked bonds their prices will be pushed above the intrinsic value suggested by our theoretical model. This is why we believe that long-dated inflation linked gilts are one of the most important protective assets in our portfolios.
If we are able to put these principles into practice the result is not only strong risk-adjusted returns, but also a return profile that is robust to change, at exactly the point at which clients need diversification most.
A limited liability partnership, registered in England with registered number OC305288 authorised and regulated by the Financial Conduct Authority © Ruffer LLP 2019. The views expressed in this article are not intended as an offer or solicitation for the purchase or sale of any investment or financial instrument. The information contained in the document is fact based and does not constitute investment advice or a personal recommendation, and should not be used as the basis for any investment decision. References to specific securities should not be construed as a recommendation to buy or sell these securities.