THE events of the past 18 months provide many lessons for investors in risk management and the way that investment portfolios are created. Risk is a rather esoteric concept that has different meanings. It may be seen as the risk of a capital loss, or the volatility of an investment, or the risk a portfolio won't generate enough returns to enable an investor to live off them in retirement.
There is no simple definition but most tend to focus on the volatility of an asset as the best guide to risk.
Traditionally, a key approach to managing the risk of an investor's portfolio was to combine a mix of defensive assets, where the bulk of the return comes from income -- namely cash and government bonds -- and growth assets, where there is significant potential for higher returns from rising capital values but also more volatility, mainly equities and property. This approach saw investment funds categorised according to their mix of defensive and growth assets.
For example, superannuation funds with a mix of 30 per cent defensive assets and 70 per cent growth assets are aimed at investors with a longer time horizon, whereas funds with a mix of 70 per cent defensive assets and 30 per cent growth assets are aimed at investors who may be closer to or in retirement.
However, for various reasons this approach was called into question and gave way to a more sophisticated approach that was less constrained by the growth-defensive pigeonholing of assets, but was risk control coming via a more diversified mix of assets.
Several considerations drove this, among them the search for higher investment yields, the blurring of various asset classes and the bursting of the tech bubble in 2000. Rising computing power and the growth of sophisticated quantitative techniques for measuring risk allowed and encouraged more sophisticated risk controls than just the pigeonholing of assets into defensive and growth.
As a result, there was more use of real estate investment trusts and hedge funds as a partial replacement for government bonds to give a higher yield.
Private sector debt came into fixed interest portfolios, and there was more exposure to exotic investments such as various credit-based investments with abbreviations such as CDOs (collateralised debt obligations) and CLOs (collateralised loan obligations), emerging market equities and debt, private equity, commodities and infrastructure, on the grounds they would provide more diversification. Comfort was provided for such adjustments via quantitative risk analysis, often based on short periods of data, which showed that such investments were relatively low risk or that they were lowly correlated to equities and hence could reduce the riskiness of an investment portfolio. Risk budgeting (or the allocation between competing investments based on their contribution to a portfolio's target volatility) became a key buzzword.
The quantitative measurement of risk in turn gave investors confidence the riskiness of their portfolio was under control.
Then came the global financial crisis to highlight the role for the traditional growth-defensive approach to risk control and the difficulties in purely quantitative measures of risk. While developed country share markets have had falls of 50 per cent to 60 per cent from their 2007 highs, many of the so-called diversifiers also had big falls at the same time. Emerging market shares and commodities lost nearly 60 per cent of their value and private equity funds had losses of 20 per cent or so. On the flip side, government bonds had good returns last year (with Australian bonds returning 15 per cent and cash 7.6 per cent), while alternatives for bonds and cash did poorly. Supposedly well diversified investments in CDOs, which in turn invested in US sub-prime mortgages, in some cases lost most of their value. Corporate credit-related investments had losses ranging up to 26 per cent for US high yield debt.
Real estate investment trusts, long viewed as a relatively safe investment, lost 70 per cent to 80 per cent of their values, while hedge funds lost about 20 per cent of their value. (Unlisted property and infrastructure held up but this may partly reflect the lagged nature of their valuations.)
Several important lessons emerge on managing the risk of an investment portfolio.
First, quantitative measures of risk and correlation are inherently unstable. During the past two years the volatility of Australian REITs has more than doubled; indeed, they have become more volatile than shares. In tough times, when you can't sell what you want, you sell what you can, and this occurred during the past year, spreading the crisis between asset classes. So while correlations between assets may be low in more normal times, the experience of the past two years is a reminder that in tough times it is likely to shoot up, just when you don't want it to.
Second, and inherent in all of this, is the reality that risk and correlations between assets are not a given but influenced by the actions of investors. The more investors observed that A-REITs were relatively stable and commodities had low correlations to shares, the more investors jumped on board both asset classes, which was one factor that ultimately contributed to their collapse.
Third, flowing from all this, it is clear that there is a lot of value in the rather simplistic yet old-fashioned approach to risk control; government bonds and cash did provide good diversification last year. Assets such as REITs, hedge funds and credit are much higher risk.
Fourth, risk cannot be divorced from valuation risk. The more an asset's price goes up, the higher the risk of an eventual fall. Unfortunately, historical measures of volatility can't capture this (although there is some evidence that low volatility in an asset class and the complacency it may represent could be a precursor to price falls).
Finally, flowing from all of this is that diversification doesn't necessarily justify a higher exposure to risky assets. There is a role for alternative and more exotic investments in portfolios, particularly once their medium-term return potential is allowed for. But their diversification benefits should not be exaggerated. Quantitative estimates of risk and diversification need to be combined with qualitative assessments, and there is no real substitute for government bonds as a portfolio diversifier and defensive asset class.
Shane Oliver is head of investment strategy and chief economist at AMP Capital Investors.
