CPD: Evolution or extinction? How three layers of defence in portfolios can help smooth an investment journey

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Ten years ago, Australian share investors had enjoyed their fourth consecutive financial year of returns of 20% or more. With investment returns in all asset classes rising, many thought it was more important to focus on capturing high returns with low volatility, rather than to diversify between asset classes.

It was a time where choosing the right investment manager was considered more important than being in the right investments. However, the global financial crisis of 2008/09 and European debt crises in 2010/11 shattered this mindset.

The crucial questions for portfolio construction

Today, asset allocation is as important as it has been for the best part of the past four decades. With central banks worldwide having stepped in to provide additional liquidity to uphold the global economy, additional funds have flowed into financial markets and sent valuations above historic averages in most asset classes.

Looking ahead, this means that investors have not only had to accept the notion of potentially lower returns from this point onwards, but are also having to determine how to diversify risk between asset classes and within asset classes.

In many ways ‘risk management’ is an ambiguous term; it can mean anything to anyone. Nevertheless, the key aspect when constructing investors’ portfolios should not be ‘How do we avoid risk?’, but instead ‘How is risk defined?’ and ‘How is it managed?

Short termism and longevity: a toxic mixture

The world has possibly never been so short-term in its thinking as it is today. In an increasingly digitised environment, where ‘instant gratification’ reigns supreme, it can be challenging for investors to refrain from meddling with their investment portfolios; trying to ensure they’re invested ‘safely’ if volatility increases. As such, many investors are tending to hold higher exposure to traditionally defensive assets (like cash and bonds) than has been the case for 40 years.

Unfortunately, this ‘safety’ comes at a price: cash is the lowest returning asset in history and bond yields are at near record lows. Additionally, people are living longer in developed countries.

So it seems that investors are more focussed on not losing money in the short term than they are on generating the investment returns that will be necessary to fund their retirement; or to put in the language of the questions posed above, ‘How do I avoid risk’.

However, a key objective for the vast majority of investors is about trying to ensure they accumulate sufficient assets to be able to afford a desirable retirement. So if investors do not take on the right amount of risk and have the optimal asset allocation today to generate the level of returns required to fund their retirement, they may need to do one of four things:

  • Spend less today to save more for retirement
  • Retire later
  • Accept a lower standard of living during retirement, or
  • Invest in more risky assets in an attempt to boost returns.

Very few investors would find these four alternatives appealing and at Perpetual Investments we believe there is an alternative to having to choose between them.

The golden era of investing?

The business and economic conditions that have contributed to strong investment returns over the previous decades have now either run out of steam, or are reversing entirely. Globally, the steep drop in interest rates is unlikely to continue, given that many countries are either now at, or have recently experienced historic interest rate lows.

This is coupled with stalled employment growth – which could weigh on GDP growth – and businesses facing more competitive environments and unprecedented disruption that could reduce their margins in the future.

The end result of all of this has been the emergence of a significant disconnect between future return expectations, and the likely outcome for investors.

So what should you consider when constructing investment portfolios in this economic climate?

Investment implications

In this ‘lower for longer’ return environment, investors will continue to face significant challenges across a number of asset classes. In particular, many ‘defensive’ asset classes are no longer truly defensive. The issue arises from the fact that as interest rates globally have continued to fall, traditionally defensive asset classes such as fixed income, property and even infrastructure, have become considerably overvalued, and in turn may lose their defensive attributes and become inherently risky.

For investors, this may mean re-examining the role that some asset classes are playing within their portfolios, and taking a new approach to ensuring their defensive investments are truly that. The outlook for government bonds is poor – yields have rarely been lower than now. In 2016, 10 year Australian Government bond yields fell to 1.8 percent, the lowest level in 141 years – and record lows were also experienced in Japan and Germany with yields falling below zero during the course of the year. Although in Australia yields have since risen slightly to 2.6% today, to get back to the ‘average’ 5% return on 10-year bonds the value of these assets would need to drop by approximately 18% (as the value of bonds falls as yields rise).

Similarly, infrastructure asset prices have been rising as investors globally have sought the relative safety of these regulated investments in an effort to improve their returns. Many infrastructure assets have characteristics that investors typically cherish: high quality assets coupled with stable, predictable earnings streams. However, as more and more investors have flocked to the assumed safety of infrastructure, it has become overpriced; fine if you’re a seller, but not great if you’re the one buying the assets or shares in the companies that hold them.

So, where to from here?

Introducing the “three layers of defense”

Warren Buffet once famously stated “Be fearful when others are greedy and only greedy when others are fearful.” Fear and greed are powerful emotions which can push markets to extremes.
In our view, investors’ portfolios need to be constructed with not one, not two, but three layers of defence:

  1. Value and Quality
  2. Intelligent diversification
  3. Explicit portfolio protection

1. Value and Quality assets

To unpack these, let’s first look at Quality and Value. What do we mean by value? Buying any asset – be it equities, bonds, property, infrastructure – at the right price increases the probability of having a successful investing outcome. A disciplined approach to identifying high-quality, attractively valued investment opportunities – irrespective of the security or asset class – is what has set us apart for generations.
We believe that in the current environment, professional and individual investors alike should have high conviction that any asset they’re investing in is both of the right quality and has an attractive valuation.

2. Intelligent diversification

Intelligent diversification is the second layer of defence against the current economic climate. Diversification is about ensuring your exposures to sources of risk and returns are genuinely diversified. We’re not just talking about a “not having all your eggs in one basket” approach to diversification; a static or ‘set’ exposure to a number of different asset classes might get you only part of the way to having a diversified portfolio.

But some of the asset classes that appear diversified from the outside may in fact have the same underlying drivers of risk. For example, commodities is one asset class that may be seen as a source of diversification. However, indirectly, many Australian investors have significant exposure to hard commodities (like iron ore) via their equity holdings or those of their superannuation fund (for example, by holding shares in BHP Billiton or Rio).

Intelligent diversification is about firstly ensuring that you’re examining the underlying drivers of returns and ensuring diversity amongst the assets that you’re investing in, so that you have a collection of distinctly unrelated investment opportunities. In addition, it’s then about making sure your allocation to these investments is flexible and able to change as quickly as the world changes. An intelligently diversified portfolio is one that has the freedom to disregard the traditional strategic asset allocation, and instead take on a more dynamic and agile approach to risk allocation.

3. Explicit portfolio protection

The third and final layer of defence against a low return environment is about examining what will protect an investor’s portfolio in times of market stress. Minimising risk can in part be achieved by having a better breadth of investments and balance of risks.

One way to protect on the downside is to explicitly manage valuation risk – that is, avoiding investing in expensive asset classes in the first place. However, this approach can lead to investing large amounts in cash when valuations are unattractive so is insufficient as a strategy on its own.

In conclusion: equip for the journey in unpredictable markets

Looking ahead, investors will undoubtedly face uncertainty and challenges. Balancing the demographic reality of longer life expectancy with the potential investment reality of markedly lower investment returns will be challenging.

One thing that is certain is that by avoiding risk assets entirely, investors cement a reality of low returns and can cause serious detriment to their plans to retire comfortably. Therefore it is important for investors to own risk but to manage it carefully; risk management is vital, risk avoidance is damaging.

Many investors today have lived their entire working lives during this ‘golden era’ when returns have been strong, so are not only having to accept the notion of lower returns, but also try to simultaneously understand the complex prospect of how to best diversify their risk.”

Navigating the future investment environment will not be easy. Adopting an active, dynamic and risk aware investment portfolio is one way to help ensure investors are best equipped to deal with, and potentially benefit from, this unpredictability.

 

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* Source: McKinsey Global Institute, “Diminishing Returns: Why Investors May Need to Lower their Expectations”, 2016.
This brochure has been prepared by Perpetual Investment Management Limited (PIML) ABN 18 000 866 535, AFSL 234426 and issued by Perpetual Trustee Company Limited (PTCo) ABN 42 000 001 007, AFSL 236643. It is general information only and is not intended to provide you with financial advice or take into account your objectives, financial situation or needs. You should consider, with a financial adviser, whether the information is suitable for your circumstances. To the extent permitted by law, no liability is accepted for any loss or damage as a result of any reliance on this information. The PDS for the Perpetual Diversified Real Return Fund, issued by PIML, should be considered before deciding whether to acquire or hold units in the fund. The PDS can be obtained by calling 1800 022 033 or visiting our website www.perpetual.com.au. No company in the Perpetual Group (Perpetual Group means Perpetual Limited ABN 86 000 431 827 and its subsidiaries) guarantees the performance of any fund or the return of an investor’s capital. Past performance is not indicative of future performance.

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