Market noise: A clear and present danger

By Elizabeth Fry

John Lucey, the investment chief of Resolution Life Australasia says the group is set on a path of growth through acquisition.

Part of the global Resolution Life Group, the local business is currently bedding down the acquisition of AIA Australia's superannuation and investments business.

Lucey - who joined as CIO from Avant Insurance in January - says the insurer is actively looking to do more deals.

"Our internal M&A team is constantly scouring the market," he says.

Resolution Life is an in-force life insurer which means it buys acquire legacy portfolios of existing policies from other life insurers looking to exit non-core parts of their business.

Lucey calls Resolution Life's investment portfolio 'relatively resilient' and having weathered the recent market turmoil 'reasonably well' is looking to rotate more capital into higher yielding assets.

But striking a balance between risk and return can be tricky for a regulated insurer captured by prudential regulations that demand that it runs its capital as efficiently as possible.

"Regulatory requirements direct more capital to be held against risky assets," he says.

Accordingly, Lucey looks at investing through the lens of risk, return and capital efficiency.

"External managers can come to us with the most fantastic strategies imaginable, but if they are not capital efficient, they won't work for us," he explains.

The investment chief looks for an understanding of regulatory capital when recruiting team members.

"Otherwise I will have people in my investment team coming to me with 'you beaut' strategies but they are just so capital inefficient we can't use them."

Taking on more risk also involves examining the illiquidity budget to check the insurer has the right mix of illiquid versus liquid assets.

"While an in-force insurer must maintain liquidity of the book, holding too much liquidity is a risk since you miss out on the illiquidity premium in the market, which is an opportunity cost." he states.

Shape shifting

Lucey concedes that with a trading background, he had a shorter-term focus earlier in his career when he worked at ING Investment Management and ANZ.

"Typically, we would set up a strategic asset allocation (SAA) but aggressively trade tactically around that," he says.

After serving as investment chief at Avant Mutual Group and now Resolution Life, he has lengthened his investment horizon and become far more conscious of materiality.

He found that's what moves the dial.

"As I've gone through my career, I have realised that much tactical activity is related to market noise swirling around investors. You can get quite caught up in manager strategies or tactical or dynamic allocation and rotating the portfolio a couple of per cent here and there," he states.

Resolution Life uses SAA as the main driver of returns.

Lucey spends a lot of time setting the right asset class blends and trying not to get caught up in market noise.

Focusing on SAA prevents short term thinking or being overly reactive to what happened yesterday.

Accordingly, Lucey reckons that getting the SSA right sets a portfolio up for success.

He acknowledges that funds without dynamic or tactical asset allocation can miss opportunities during market routs.

But he argues that a fund's SAA matters most especially from a total portfolio management perspective.

According to the investment head, the SAA drives about 80 per cent of portfolio returns, with management alpha and dynamic tactical allocation each adding 10 per cent on top of that.

Lucey gets it.

"Implementing an SSA is just not as exciting as employing a tactical or dynamic allocation, engaging in overlay programs and dealing with external managers," he says.

"It's good fun, it's interesting, and you feel close to the market."

Lucey said success with these strategies depends on ignoring day-to-day market noise.

Therefore, he worries that the amount of short-term market noise is a big risk to investors, and he argues they would achieve better long-term performance by looking through market dislocations.

The danger is that investors are being far too reactive.

"With news, Twitter, Instagram and podcasts, everybody is an expert on anything," he says.

Over reacting to bad news

Lucey warns that the temptation to be reactive has never been greater and technology is allowing people to execute on that fear that market noise unleashes.

"It's very easy now to move away from a plan and a disciplined approach and be consumed by the noise around you. So do you stick with the plan, or change tact?"

From where he sits, there will always be some crisis or drama on the horizon, and while no two are the same, they have one thing in common.

When a crisis hits - whether energy shock or inflation shock -  it is generally too late to do anything.

Similarly, Lucey goes on to say, markets will always have periods of volatility. "It's not pleasant, but it's not unusual and it's certainly not unprecedented," he says.

As he sees it, investment professionals pull different levers during a crisis, and inflation is just another lever.

Unlike many of his peers, Lucey doesn't believe things are different this time.

In his view, if funds have the right risk profile, to begin with, there is no need to panic in a brutal market sell-off.

"So, when you are hit by a one-in-50-year event it doesn't cause you to overreact - you don't liquidate or reduce risk at the worst possible time."

We saw that in March 2020 when some super funds and insurers had to de-risk their books because of liquidity and going outside of capital requirements.

The market observed the velocity of the sell off, close to the end of quarter, funding requirements on FX hedging losses and an inability to sell illiquid assets, effectively forcing sales of heavily sold off listed assets at the worst possible time.

"You make sure your modelling is resilient enough so that doesn't happen," Lucey warns.

But what's different so far in this calendar year is that balanced portfolios were hit hard as both equities and bonds have sold off over 10 percent.

Lucey says it's probably a one in 40 or 50-year event that asset classes have been hit hard except for unlisted and cash.

As for the outlook, the investment specialist says despite the market jitters over the CPI, it looks as though inflation in the US has peaked after printing 9.1 per cent and then 8.6 per cent.

"I think the equity and bond markets have reflected the inflationary impact, and now they are starting to tilt into central banks pushing us over the edge - are they going to be reactive to noise? Are they going to hike too aggressively?"

Returning to the theme of the market noise, Lucey notes the Federal Reserve chair's speech at the central banking conference in Jackson Hole which spooked investors.  Markets fell sharply as investors realised how tough the Fed was willing to be to get inflation under control.

Yet the Fed has effectively said they will keep rates higher as inflation is a bit more stubborn than initially expected, so the comments shouldn't be a massive surprise.

"This is why bond yields in Australia got up to 4.2 per cent and are now at 3.6 as they rally in response to central bank's reaction. Reacting to noise when we are in the middle of a storm is exactly what I said investors shouldn't do."