Stephen Nash looks at the current SMSF allocation of equities versus bonds and argues the reverse allocation would play out significantly in favour of the investor.
Bonds cut risk. However, investors need to know how that risk is cut across a variety of asset allocations.
Accordingly, this article looks at a very rough estimate of a current self-managed super fund (SMSF) allocation of 75 per cent equities and 25 per cent bonds, and compares that to the opposite allocation of 25 per cent equities and 75 per cent bonds.
The results are essential reading for SMSF trustees.
Most investors realise that having too many equities tends to overload the portfolio with risk, where risk is the variation in return that can be expected in any year.
If risk is high, then the actual deviation from the average return can be large, and bonds help tighten the variation in return.
This article seeks to identify how risk changes, by adding larger and larger amounts of bonds to an equity portfolio and seeks to highlight the comparison between two specific asset allocations.
Two examples
In many ways, the following two examples might well be instructive as to how bonds can help cut risk:
- A portfolio of 75 per cent equities and 25 per cent bonds, which is the average default portfolio of most super funds and Australian SMSFs
- A portfolio with the opposite asset allocation; 75 per cent bonds and 25 per cent equities.
We expect a very wide variation in annual returns with the first allocation, and the opposite with the second allocation.
As Chart 1 shows, this expectation is fulfilled with the first allocation being represented by the dark blue line below, and the second allocation being represented by the light blue line.
Notice how the 75 per cent bond portfolio cuts down the average variation of annual return. This portfolio maintained roughly positive returns even throughout the global financial crisis.
In general, the bond portfolio allocation helps centre the annual return series, eliminating the highs, but, most importantly, reducing the severity of the lows in annual return.
Sometimes, the relationship, between bonds and equities breaks down, as in 1994, yet that is the exception, as opposed to the rule.
Marginal risk changes
As we add more and more bonds, the impact of the extra bond allocation tends to fade, as the portfolio becomes more and more like a bond portfolio.
In the case of the 75 per cent equity and 25 per cent bond portfolio, it is evident that adding extra bonds tends to decrease risk by around 80 bps, for each additional 5 per cent allocation to bonds, as shown by the light blue column in Chart 2 below.
By the time we arrive at the 75 per cent bond and 25 per cent equity allocation, the portfolio receives around only half the marginal decrease in risk, for another 5 per cent increase in the bond weighting, as shown in the beige column in Chart 2.
Yet, the important point is what happens to total annual risk and total annual return, between the two allocations.
As Chart 3 shows, the risk of the portfolio has fallen by 6.34 per cent or 634 basis points (bps), while annual return has fallen only 63bps.
Ratio of return to risk
A rational investor would prefer to have more return in the portfolio, on average, than risk.
Yet, the current default allocation in Australia, as represented by the light blue column fails to deliver more return, on average, than risk; coming in at around 80 per cent.
That means that on average, investors will incur more risk than return. Here, the 75 per cent equity/25 per cent bond portfolio returns around 9.79 per cent and has a risk of 12.19 per cent.
A much better position is where annual return is greater than annual risk, as occurs in the beige column below, where 75 per cent bonds are held along with 25 per cent equities.
Here, the portfolio has an average annual return of 9.16 per cent, with an annual risk of 5.85 per cent. (See Chart 4)
Risk–return trade-off
All these results can also be summarised by Chart 5, which expresses the trade-off between risk and return for various portfolios of bonds and equities, with a series of dark blue dots for various asset allocations where bonds are increased by 5 per cent, from 0 per cent to 100 per cent.
All the below points correspond to portfolios of bonds and equities, where the highest return portfolio corresponds to a 100 per cent equity portfolio, and the lowest return is the 100 per cent bond portfolio.
The light blue dot refers to the 75 per cent equity – 25 per cent bond portfolio, while the beige dot refers to the 75 per cent bond – 25 per cent equity portfolio.
While the return differential, between the beige and light blue dots, is small, the risk differential is large.
If Chart 5 had the same scale on both axes, then the upward sloping line in Chart 5 flattens right out. In other words, bonds can combine with equities not to cut return, as is typically assumed, but to cut risk.
Conclusion
In an environment where the consumer has become cautious, one can expect that investors have done the same thing – they have become more conservative.
In many ways, this article tells how to implement this newfound conservatism; cut risk and allocate more to bonds and less to equities.
More specifically, this article compares a variety of asset allocations, and focuses on two main allocations: one dominated by equities (75 per cent equities – 25 per cent bonds) and one dominated by bonds (75 per cent bonds – 25 per cent equities).
While most funds and investors have the former allocation, the latter has a much better ratio of return to risk. Importantly, by having the latter allocation, risk can be cut 10 times more than return, such that risk is more than half that of the former.
In other words, investors need a better investment deal, and bonds help investors extract the very best out of the risk-return trade-off.
Dr Stephen Nash is director of strategy and market development at FIIG.
