Diversifying key to minimising equity risk

Jim Franks

To reduce equity risk in portfolios, investors should consider diversifying into property, credit and bonds, according to Russell director of investment consulting Jim Franks.

Franks said 90 per cent of volatility comes from equity investments in a portfolio. Speaking at the Russell conference in Melbourne, Franks said property (both listed and unlisted) generates only around 20 per cent volatility and fixed income 11 per cent.

“The aim of switching investments is to reduce the reliance on equities in the portfolio,” Franks said.

“We are recommending people look at property and infrastructure [and] credit and bonds to diversify the fundamental risk exposure of the portfolio.”

Franks believes this strategy will deliver excess returns, but warns that investors should watch the liquidity risk of unlisted vehicles.

Property and infrastructure investments will reduce inflation and economic risk exposure, but these strategies require a skilled approach to picking the right manager, Franks said.

“A manager with competitive advantages such as access to deals and economies of scale has the potential for excess returns,” he said.

“There is also the liquidity provisions and risk transfer in large global managers.”

However, such an investment is not without risks, as some investments face liquidity issues and could still be exposed to inflation risk through interest rate movements.

Opportunistic credit is looking attractive at present due to the wide credit spreads, Franks said.

“Systemic illiquidity is the likely cause of an opportunistic strategy based on liquidity provisions,” he said.

“We are expecting handsome returns in a market starved of liquidity.”

Again, the risks of the strategy are illiquidity issues with some investments and the danger of an unintended liquidation of an asset.

Franks said an overlay using a large sovereign bond component can be more efficient than the traditional equities/bond mix.

“The reason for the diversification is the reduction of economic risk,” he said.

“The overlay of long bonds/short cash over a long-term horizon should generate excess returns.”

Before employing such an investment strategy, a portfolio manager should be looking at the structure of the investment and the manager, Franks said.

A revised portfolio could see almost equal weightings of fixed interest and equities, with 13 per cent allocated to other asset classes such as property or commodities.