Exclusive: AIMCo CIO MacMaster on Low Yielding Markets

March 30, 2015 by Loch Adamson

Exclusive: #AIMCo CIO Dale MacMaster on Fixed Income Investing
#AIMCo Makes Opportunistic Investments in Oil Firms
#AIMCo CIO MacMaster's Outlook for 2015
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The Alberta Investment Management Corp.  (AIMCo) was created in January 2008, just a matter of months before the collapse of Lehman Brothers Holdings. But under the leadership of Leo de Bever, CEO and CIO, AIMCo survived the financial crisis and has built a reputation as one of the world’s pre-eminent and technologically-savvy institutional investors, returning an annualized 8.8 percent since inception. AIMCo now manages some C$80 billion ($62.5 billion) for 27 pension and endowment funds in the Canadian province, including sovereign wealth vehicle the Alberta Heritage Savings Trust Fund.

In January 2015 Dale MacMaster, former head of public market investments at AIMCo, took over as CIO following de Bever's retirement. In this, the first of a two part interview, he spoke to Sovereign Wealth Center’s David Evans about how AIMCo is pursuing opportunistic sources of yield in a challenging market environment. The transcript has been edited for grammar, space and context.

SWC: What are the key investment challenges AIMCo will face in 2015?

The main challenge we face, and that all investors face, has been this unusual period of low interest rates. Historically, on 10-year bond yields, you expect to have a cushion of 200 to 250 basis points over inflation, and now there are many jurisdictions where we have negative real rates. It’s an highly unusual situation, a highly contrived position that the central banks have put us in. And [the banks] have wrestled away any counters to their policy.

Years ago there were the so-called bond vigilantes; if they felt the central bank policies were wrong they would react. But the central banks have now wrestled that completely out of the system, and it’s a very complacent situation in the bond markets today.

SWC: How have low yields changed your outlook on other asset classes?

Those low rates have everything else — all assets — looking very expensive. Because all assets are essentially priced off the U.S. yield curve, prices are high not only on other sovereign bonds, but also on hard assets like real estate and infrastructure. Investors have fled low interest rates and taken on more risk, so there’s also an element of moral hazard to this too; in order to achieve the rates of return they want, otherwise conservative investors have started to reach from government bonds to corporate bonds to high-yield and mezzanine debt, to equity and infrastructure, timber, structured notes, you name it. Everyone has been reaching.

And so far, it’s all worked out, because when equity markets start to correct, central banks are quick to calm markets down. The real challenge moving forward is how we transition to a more normalized interest rate environment, and we’re going to see that I think this year, maybe in June, maybe in September in the U.S. But I think it’s fair to say that the transition to this new interest rate environment is not going to be easy or without volatility. So I’m cautious.

SWC: Has the situation had an effect on your views on stocks?

If you look at valuations in equity markets, they look a bit stretched to me, especially in the U.S. And we could easily see a correction in the markets as we transition. It’s just not reasonable to expect that equity markets will continue to go up as interest rates rise. So either that’s going to be a rough ride, or central banks will back away. That’s the challenge: Either we move down a path of higher interest rates and get higher volatility, or we don’t, and we’re faced with this continuing environment with low rates of return.

We’ve been very fortunate over the last four, five, six years; coming out of a bull market, all of these assets have inflated, but I think the day of reckoning has finally come. If you ask me where ten-year returns on bonds are going to be over the next ten years, you’re going to be flat to negative. So there’s no hiding in fixed income. And equity markets look volatile.

Also, because everyone’s flocked to the illiquids — real estate, infrastructure, timber — those look inflated too, and of course now there are retail products on some of those and that’s caused some of those prices to be inflated even more. There’s no hiding place, is what I’m saying. My philosophy is that sometimes you can’t force the market, you have to take what the market gives you. If you’re patient, you’ll get an opportunity.

SWC: In which sectors are you looking for opportunistic investments?

Energy is a good example. Very few people would have predicted that oil prices would drop by 50 percent or more. As an investor you can’t control that, but you can control your reaction to it. As a value-type investor with a long-term horizon we can afford to wade into those areas and pick away at quality energy names with strong balance sheets.

Going into October when energy prices started to fall off, we were underweight energy. When oil hit the $65 range we saw some opportunities, because markets like to react first and ask questions later. We did a few things: we created a basket of securities in the energy small-cap mid-cap area, and started to pick away at those names. It’s a bit odd, but even as energy prices fell and looked like they were stabilizing at around $45 to $50 dollars those stocks actually bounced, and we made a profit in them.

 SWC: What is your outlook for energy going forward?

We will continue to mine that theme, and I think we’re going to get another opportunity. In the short term, supply/demand dynamics are such that as we move into spring, we could see another leg down — and that would be the final opportunity for investors to really get in at an opportunistic price. Why I’m optimistic about energy is that if you look at energy demand over the past 35 years it’s gone straight up.

Demand has been consistent. What we had was a short-term supply issue, driven by North American fracking resulting in the U.S. getting market share. I think it’s temporary and it will rebalance at a higher price. What we do know is that above $100 more oil supply comes on the market than can be satisfied by the demand. But at a price around $70 to $75 we’ll find an equilibrium. 

In the energy area you don’t see many opportunities like this. I know there’s a lot of people going around saying: this time it’s different. I quite frankly don’t believe it. Every time [an oil price collapse] has happened in the past, looking 12 months to 24 months out you’ve had very nice double-digit returns on things like equities and even debt-related opportunities in energy. Call me a bull. I can be afforded the luxury of time as a long-term investor.

SWC: Turning back to yields, what’s your outlook on fixed income?

As an asset allocator we’ve been long equities and short bonds in our portfolio for a while now. I would say now we’re getting a little closer to home. It’s really more about the equities than the bonds; we’ve actually seen little opportunity in bonds for quite some time now. We do interest-rate risk and credit risk in the fixed income portfolio, we lived through 2007 and 2008 and those were pretty nasty times. As a bond investor you have to be somewhat of a contrarian. Unlike equities, bond yields and credit spreads go up and down; and now we’re at a time when interest rates are low and credit spreads are tight,and you just have to get out. You have to be underweight, and be patient. 

SWC: What would kind of catalyst would change your perspective?  

If we get a decent equity market correction, credit spreads will widen, we’ve already seen high-yield widen quite a bit due to the energy high-yield bonds in there. We’ll see lots more of that. What I’m saying is you can’t force the market, you have to be patient, sometimes there are periods when returns are simply low. 

But you have to set yourself up to be in a position to take advantage when the crisis hits and there are forced sellers. And there will be lots of forced sellers in the next crisis, which we will inevitably get every four or five years; whether it’s from exchange traded funds in over the counter [OTC] markets that don’t have the liquidity, the regulatory changes we’ve seen in banks, that have eliminated prop [proprietary trading] desks and really restricted their ability to act as a natural buffer in the market — because they don’t use their balance sheets any more to carry inventory.

Without that natural buffer in the market, some of these OTC prices will simply gap down and pension funds and other investors with a long term horizon, a strong balance sheet and lots of liquidity can take advantage. And those are the times when you make your decade. In the meantime returns aren’t going to be great and that’s just the way it’s going to be.

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