While many investors are moving to a more nuanced understanding of risk, old habits die hard. Some assume that managing a portfolio’s volatility and correlation is enough to ensure proper diversification and an appropriate asset mix, but our multi-asset solutions team believe that assumption is flawed.
Volatility has become a handy byword for risk. In this view, cash is the safest asset because it has no volatility at all, while assets such as emerging markets are inherently risky. Following this logic, if you combine low volatility assets and high volatility assets in different ways, you arrive at a combination that works for different types of investor.
Clinging to cash almost guarantees you will not meet your goals
If you are a long-term investor, who needs to grow their wealth by inflation or higher, cash isn’t a ‘low risk’ investment at all. In fact, it almost guarantees that you will not meet your goals. At the same time, if an investor has a longer-term investment horizon, it can be beneficial for them to include some volatile assets to maximise their chances of achieving an inflation-plus return.
It assumes the volatility of assets is static, which is a poor assumption. Although we have seen a period of relatively benign volatility recently, that could be derailed by a change in the monetary policy environment, or heightened geopolitical tension, or any number of other factors. To assume that the future will look just like the past is a human instinct but is rarely an accurate guide.
Volatility is not always bad for investors
It also assumes that volatility is necessarily bad. Certainly, it can be unnerving, but it can also create investment opportunities: at its most simple, the prices of assets fall, which makes them more attractive. It allows investors to rebalance their portfolios into investments they may not have considered when prices were higher. In this way, volatility can be a real advantage when managing a portfolio. Where investors are assuming a low level of volatility into the future, it is also possible to take advantage via protection strategies. These option strategies can reduce tail risks for a portfolio at low cost. During the French elections for example, we added this type of protection. This strategy is particularly useful when there are binary outcomes. Rather than trying to predict the outcome, we instead try and protect the portfolio against the associated short-term volatility.
At the same time a lot of asset models assume a fixed correlation between asset classes. The 60/40 model still forms the basis for many mixed asset portfolios, for example, particularly among passive investors. Rebalancing to this model assumes that this will always provide adequate diversification because equities and bonds are weakly correlated.
However, it exposes an investor to uncontrolled risks. Regardless of the trends within an underlying asset class, the asset allocation remains the same. This is particularly difficult for passive investments, where the composition of bond indices has changed to incorporate more government bond exposure at the expense of credit-sensitive sectors such as securitised and corporate bonds. The duration of passive indices has also moved higher, while yields have moved lower. Investors are taking a whole different set of risks, even if the asset allocation remains the same.
It’s difficult to see assets behaving the same way again
There is always a significant range in terms of the correlation between assets. If you look at the three-year rolling correlation between bonds, correlation goes as high as 0.8% and as low as -0.7%. The average may be 0.1 – and look like low correlation – but this ignores changes based on market dynamics.
During the global financial crisis, bonds proved a good diversifier for equities. Since then, central banks reduced their overnight borrowing rates significantly. There was an uplift for financial assets in the end, but there is now not as much room for them to repeat this performance. Today, the market environment is very different. It is difficult to see financial assets behaving in the same way again.
A more dynamic approach takes into account how assets behave when combined together. We make an assessment of the valuation – what we are paying for the asset, what income we expect to receive. In an environment where we are being paid less income for holding a bond, will that income still provide an offset in adverse market conditions? We believe this type of approach works better to create a consistently diversified portfolio, which adapts to different market conditions.
This material has been prepared and issued by First Sentier Investors (Australia) Limited (ABN 89 114 194 311, AFSL 289017) (Author). The Author forms part of First Sentier Investors, a global asset management business. First Sentier Investors is ultimately owned by Mitsubishi UFJ Financial Group, Inc (MUFG), a global financial group. A copy of the Financial Services Guide for the Author is available from First Sentier Investors on its website.
This material contains general information only. It is not intended to provide you with financial product advice and does not take into account your objectives, financial situation or needs. Before making an investment decision you should consider, with a financial advisor, whether this information is appropriate in light of your investment needs, objectives and financial situation. Any opinions expressed in this material are the opinions of the Author only and are subject to change without notice. Such opinions are not a recommendation to hold, purchase or sell a particular financial product and may not include all of the information needed to make an investment decision in relation to such a financial product.
CFSIL is a subsidiary of the Commonwealth Bank of Australia (Bank). First Sentier Investors was acquired by MUFG on 2 August 2019 and is now financially and legally independent from the Bank. The Author, MUFG, the Bank and their respective affiliates do not guarantee the performance of the Fund(s) or the repayment of capital by the Fund(s). Investments in the Fund(s) are not deposits or other liabilities of MUFG, the Bank nor their respective affiliates and investment-type products are subject to investment risk including loss of income and capital invested.
To the extent permitted by law, no liability is accepted by MUFG, the Author, the Bank nor their affiliates for any loss or damage as a result of any reliance on this material. This material contains, or is based upon, information that the Author believes to be accurate and reliable, however neither the Author, MUFG, the Bank nor their respective affiliates offer any warranty that it contains no factual errors. No part of this material may be reproduced or transmitted in any form or by any means without the prior written consent of the Author.
In Australia, ‘Colonial’, ‘CFS’ and ‘Colonial First State’ are trade marks of Colonial Holding Company Limited and ‘Colonial First State Investments’ is a trade mark of the Bank and all of these trade marks are used by First Sentier Investors under licence.