Its all about risk – comparing two portfolios
Guest Post – by Dr Stephen J Nash
Director – Strategy & Market Development
We have commented previously on the way Dr. Ken Henry has supported some of our common sense arguments, and the press reaction has been predictable; equity market proponents have steered the discussion back to return and away from volatility and capital stability as evidenced in the article, “The pros and cons of being overweight equities: Franking credits and high yields create a powerful incentive to be long equities” in The Weekend Australian last Saturday. Initially, this article will review the press response to Dr. Henry’s comments, and then compare two portfolios:
- A “default” portfolio, with 70% equities, 20% bonds, and 5% cash
- Then a portfolio weighted towards bonds, with 70% bonds, 20% equities, and 5% cash
While the returns of each portfolio are comparable, the risk is not. In other words, investment is not just about the overall return, but it is also about the potential volatility and the risk of loss in any one year. A greater allocation to bonds smooths the ride, allowing investors to achieve their investment goals in a more effective way, where investors receive adequate return for the risk that they are taking.
Dr. Henry has indicated that the default allocation to “growth” assets in Australia, of around 70% is much higher than global peers, where most global peers hold over 50% of the portfolio in conservative assets like bonds. While fund managers defend the current allocations on the basis that “average” returns are better in equities, Henry argues that “average” returns are inappropriate for many investors, especially older investors, as Dr. Henry indicates,
Depending upon when they enter the system and when they retire, some fund members will benefit enormously from a portfolio weighted heavily toward equities while others will lose big time … And nobody knows, in advance, who will win and who will lose*.
In other words, the focus should be on risk management, not return.
In investing, “risk” refers to the annual standard deviation of return, where the standard deviation shows the dispersion of data around the annual average return. In other words, return typically refers to the annual average return, while risk refers to how variable that average might, or might not, be, on an annual basis.
An example might be of assistance.
If the average return for an investment, say bonds, was 8%, with a standard deviation, or risk estimate, of around 5%, then most of the time, (about 68%, assuming a normal distribution) one can expect a return within 5% of the average; between 3% and 13%. Further, almost all of the time (about 95%) return will be within 10% of the average, or between negative 2% and 18%; two standard deviations.
If the standard deviation were zero, then one would expect that bonds would always return 8%.
In the alternative, if the standard deviation were twice as big, say 10%, then bonds would have much more variable returns, with a one standard deviation range of about negative 2% to 10%.
Reaction – Misses the point
As the Weekend Australian indicates, the standard response to these comments focused on return, along the following lines:
- Investors can lose money in bonds
- Returns are low, relative to equities, as Ivor Ries, Head of research at EL&C Baillieu argues “The dividend yield on the top 100 Australian shares for the current year is around 5 per cent … “**
In other words, the focus is immediately taken off risk, and placed back on return, despite the efforts of Dr. Henry to make investors think about risk. We agree that investors can lose money in bonds, as they take investment risk, like any other securities. However, the really important point to note is how bonds reduce volatility and smooth portfolio returns, because bond returns are generally negatively correlated with equity returns.
Correlation refers to the degree to which the investment returns of one asset class move with, or in the opposite way, compared to another asset class. When return correlation is positive, the annual returns of asset classes move together; they move up together and they move down together. By way of contrast, when they are negatively correlated, the annual returns move in opposite ways. As Figure 1 shows, bond annual returns generally move in the opposite direction to equity returns, apart from ephemeral periods, like 1994. Importantly, investors need to focus on the relationships that occur most of the time, not the odd unusual situation.
Simulated portfolio data
Given the high risk nature of equity investing, as implied by the much larger scale of the left hand axis, compared to the right hand axis in Figure 1 above, it would be instructive to see how two portfolios performed, with large variations in equity holdings. First, we will consider the default portfolio of Australian superannuation, which has a high equity weight. Second, we will consider what can be called ‘the FIIG portfolio’, with a large allocation in bonds. It is possible to simulate the performance of these portfolios using the following indices:
- (Cash) UBS Bank Bill from 1989 to March 2012, daily
- (Bonds) UBS Composite Bond 0+ years, from 1989 to March 2012, daily
- (Equities) ASX All ordinaries, accumulation, from 1989 to march 2012, daily
More specifically, the portfolios have the following asset weightings:
- Default, 70% equities, 25% bonds, 5% cash
- FIIG, 70% bonds, 25% equities, 5% cash
These weightings result in the annual returns shown in Figure 2 below, Notice how the FIIG portfolio, the dark red line, is much less volatile than the default portfolio, or the dark blue line, in Figure 2 below. While the return becomes slightly negative in the GFC period of 2008-9, for the FIIG portfolio, it is nowhere near the default portfolio’s return.
Now, given the lack of variation in the FIIG portfolio return, one might expect that the FIIG portfolio returns a lot less than the default portfolio. However, the FIIG portfolios average annual return is 9.03%, while for the default it is 9.72%. In other words, the FIIG portfolio returns the vast bulk of the default portfolio return, roughly 93% of the default portfolio return, with much less risk. Specifically, the FIIG portfolio has 50% of the annual risk, compared to the default portfolio.
If we calculate the rolling annual risk for each portfolio, we can effectively chart how risk changes over time. While investors are used to viewing return simulations, annual risk simulations, as shown in Figure 3, are quite unusual. However, FIIG would argue that the risk history of the portfolio is just as important as the return history. More specifically, when equities rise in price, the risk differential, between FIIG and the default portfolio shrinks, yet when equities fall in price, the risk differential rises dramatically.
Dr. Henry reminds investors that investing is all about risk. While recent commentary, based on the remarks of Dr. Henry, obscures that message, FIIG supports it. Importantly, this piece shows that it is not just the investment outcome that is important; it is also about how you get there. Risk is the metric that helps investors gauge the degree to which they can engineer a smooth path towards achieving investment objectives. When you can achieve roughly the same investment return outcome with half the risk, through using more bonds, then it’s worth exploring.
* “Funds should be more conservative – Henry”, by Clancy Yeates, Sydney Morning Herald, March 17, 2012. See also, “Superannuation funds are overweight on shares, warns Henry”, by David Uren, the Australian, March 17 2012
** “The pros and cons of being overweight equities: Franking credits and high yields create a powerful incentive to be long equities”, 24 March 2012, pp. 33-5