Following the GFC, more investors have been turning to strategic risk allocation as a way of combating the excessive potential risks associated with equities, as James Walker-Powell and Louis Seco explain.
When you look at the movements between traditional growth assets – such as Australian shares, international shares and listed property – over the past 30 years, what you see is that these asset classes move more or less with one another.
Up until a few years ago, you and your portfolio were accepting of the risk within a typical growth portfolio. For example, from late 2002 until late 2007, you were being rewarded for accepting this risk, with an average 20 per cent compound return per annum on Australian shares. Investors were absolutely content, and an element of complacency crept in – and basically, these portfolios of investments stayed heavily weighted to assets such as equities and listed property. It was easy to lose sight of the underlying risk created by shares.
The typical allocation to Australian and international equities within a growth portfolio is shown in the following diagram.
The portfolio typically has an equities component of 50-60 per cent, including Australian and international shares. A lot of portfolios were set up this way prior to the global financial crisis (GFC), and inadvertently exposed to excessive potential risk.
When the GFC hit in late 2007, your portfolio more than likely was exposed to this excessive equities risk, and you may have seen the value of your precious retirement savings plummet. Growth asset classes depreciated – and the substantial correlation between these asset classes made things even worse. Generally, this experience has made us more aware than ever that the tempting upside of investing in growth assets, such as equities, can come at a hefty price.
In fact, the risk from growth asset classes accounts for about 85-95 per cent of the total risk of a typical growth portfolio (see diagram below), which can have an immense impact on realised returns.
In order to combat this excessive risk and possibility of fluctuating returns, the strategic risk allocation (SRA) approach can be adopted. This attempts to address risk and the volatility of returns via managed funds that make use of alternative investment strategies. We believe an alternative portfolio construction, which aims to reduce the effects of such turbulent economic times, can add significant value to your portfolio – because it aims for reduced volatility of expected returns compared to the traditional growth assets classes.
Given the increased popularity of the SRA approach, portfolios are now becoming more and more constructed not around asset class, but with alternative investment vehicles such as managed futures, market-neutral funds and event-driven strategies – so you can achieve a truly diversified portfolio that can deliver consistent returns, no matter what the market is doing. The ultimate aim is to provide a smooth and reliable stream of returns.
In summary, our belief at More4Life Financial Services is that the SRA approach to investing – which incorporates alternative investments – can be beneficial in terms of providing a more accurate risk-targeted tactic to produce real results.
Volatility of returns makes a big difference to the bottom line, especially in the pension phase.
The example below (adapted from a May 2011 article by Doug Turek in the Eureka Report) shows two lots of annual returns. In the first series (portfolio A), the return does not vary, while in the second series (Portfolio B), the returns are volatile.
After compounding, a $100,000 initial investment would have grown to $236,736 in portfolio A after 10 years. This is $17,491 more than portfolio B, which has volatile returns.
Now, instead, let’s consider a retired investor who starts with a $1 million principal portfolio value and draws out $100,000 at the start of each year, to live on. After 10 years, the retiree who was invested in portfolio A (which earned the steady 9 per cent return) would still have $711,334 remaining, while the other retiree invested in the more volatile portfolio B would have only $459,891 left. That is a $251,443 difference.