SMSF Investing Education & Strategies

Risk Allocation

Why a Substantial Allocation To Bonds Is Needed

by Dr Stephen J. Nash
FIIG Securities.

Return is a really important aspect of investing, yet risk is also critical, and often overlooked. Recent equity market risk has highlighted the fact that portfolios can very easily have the entire risk exposure being dominated by equities.

What this means is that if a portfolio has too much equity exposure, then the portfolio does not hold adequate insurance against equity risk; equities effective hijack your portfolio risk diversity.

 

Allocating only one quarter of the portfolio to long bonds is shown to be not near enough, and even 50% is probably not enough. However 50% bonds is much better, from a risk diversity perspective, than 25%. Investors, who want an antidote to recent equity risk, therefore require more bond exposure than they are likely to possess, as this article indicates.

 

Risk

While the idea of return is widely understood, the idea of risk is not as widely understood. Risk refers to the annual standard deviation of return. Before you go to sleep, all this means is that you can expect that the average return to vary in any one year, assuming a roughly normal distribution, in roughly 68% of cases, that the return of equities will be between -5% and 27%, where the ASX All ordinaries accumulation index has an average annual return of 11%, and a standard deviation of around 16%.

 

Risk allocation

Risk allocation is important, as it means that if the portfolio does not have adequate diversification, then the portfolio will be dominated by the return from one asset class. Since equities have a very high risk level, the portfolio risk can very easily be dominated by equity risk, until an adequate level of diversification is added to the portfolio. This means that longer interest rate risk needs to be added to the perpetual risk of equities To illustrate the point we compare a portfolio allocation to long bonds of 25% with a 50% allocation. Adding bonds can be done in a way that reduces risk and does not drag portfolio return substantially, since corporate securities offer some very attractive returns. Some investment grade bonds are now trading over 10% in yield, such as AXA and Swiss Re fixed; even better levels than before the recent fall in equity prices. Also, some inflation linked bonds (ILBs) are trading above 5% real offering very attractive equity like returns for much lower risk.

 

Risk allocation - 25% long bonds

We have analysed the impact of taking credit risk and interest rate risk on an equity portfolio. We found that the inclusion of long dated bonds almost halved overall portfolio risk, or annual risk, and that the return drag was minimal; around 1% for a portfolio of 50% long dated credit and 50% equities. This research was supplemented by additional work, published on 17 August 2011, entitled “Take a risk holiday, use long bonds to cut portfolio risk”, where similar results were obtained.

Essentially, this research indicated that when equities are combined with bonds the risk of the portfolio falls dramatically.

 

Combining bonds with equities reduces risk, but not at the cost of substantial falls in return, as the two asset classes largely move in opposite directions. If investors seek to diversify risk, so that it is not overly dominated by equity risk, then the question remains as to how much fixed income is enough to achieve greater diversity of risk.

 

If an allocation of 25% to long bonds was used to diversify the risk of equities in a portfolio, then investors can look at the risk of the underlying asset classes, as they relate to the portfolio risk. On the one hand, investors can see how much portfolio risk is attributable to equity risk, as shown in the dark blue line in Figure 1 below. On the other hand, they can see how much portfolio risk is attributable to bond market risk, as shown in the light blue line in Figure 1 below.

 

As Figure 1 shows, the use of 25% long bonds is not enough to diversify the risk of the portfolio. Yet the time series of attribution, between equity risk and fixed income risk, shown in Figure 1 below shows that such an allocation hardly changes the risk attribution of the fund. Here, the portfolio remains dominated by equity risk, as equities have a very high level of risk, and the addition of just 25% of long bonds is not adequate to really lower that high risk. Such analysis suggests that a 25% allocation to bonds is not enough to materially diversify the portfolio risk, since Figure 1 shows how the risk is dominated by equities at almost all times.

 

 

Figure 1

 

While Figure 1 shows how the allocation of risk varies over time, and during different market conditions, it is also possible to summarise the average allocation of risk, between bonds and equities, in Figure 2 below. In other words, the average values of the above time series can be derived and shown in Figure 2 below. Here, the portfolio is dominated by equity risk; roughly 87% of risk is equity risk, since the power of equity risk is such that bond risk cannot significantly overcome this quantity of risk, even when long bonds are used as a way to offset that risk.

 

Figure 2

 

Risk allocation - 50% long bonds

Increasing the allocation of bonds, to 50%, from 25%, can improve the overall risk diversity of the portfolio substantially, so that bonds tend to boost the risk diversity of the portfolio, especially in difficult times for equity markets. If an allocation of 50% to long bonds was used to diversify the risk of equities in a portfolio, then one can look at the risk of the underlying asset classes, as they relate to the portfolio risk. On the one hand, one can see how much of portfolio risk is attributable to equity risk, as shown in the dark blue line in Figure 3 below. On the other hand, one can see how much of portfolio risk is attributable to bond market risk, as shown in the light blue line in Figure 3 below.

 

Figure 3

 

Over time, the increased allocation to bonds tends to substantially improve diversity of risk away from equities. Here, equity risk is lower, when compared to Figure 2, at around 70% of risk, which is a substantial improvement on the situation in Figure 2 above. This is because the risk of equities is so large that it needs a substantial offset, through a 50% allocation to long bonds, in order to dampen and diversify equity market risk. Smaller allocations do not have a great enough impact on portfolio risk diversity.

 

 

Figure 4

 

Although risk is still dominated by equity risk, since that risk is so large, the risk allocation is much more diversified, when compared to a 25% allocation to bonds. Specifically, around one third of the portfolio risk is now attributable to fixed income risk, around double what it was with a 25% allocation to long bonds. Also, the diversity of the portfolio should improve in stress periods, as Figure 3 indicates, where bond risk rises, as cash rates fall with expectations of growth collapsing in line with equity prices.

 

In an ideal world, investors would need to move towards a 75% allocation to long bonds in order to balance the risk of equities, as Figure 5 indicates below. Here, equity risk is only 45% of the portfolio risk, on average.

 

 

 

Figure 5

 

 

Conclusion

Risk is a worrying theme that has been emphasised during the recent equity downturn. In addressing this theme, investors need to allocate a substantial part of the portfolio to bonds; 25% is just not enough. Towards 50% seems like a more adequate allocation of bonds in the portfolio, where the much greater risk diversity of the portfolio becomes apparent. Importantly, this risk diversity does not mean less return with investment grade credit still offering returns of around 6-10%, and inflation linked debt available at over 5% above the rate of inflation (as at Sept 2011).

 

Dr Stephen J. Nash
Director - Strategy and Market Development- FIIG Securities.

 

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