Drill deeper to find risk

Advisers need to drill deeper into client portfolios to find the hidden mega risks that will affect returns, a Russell researcher has warned.

“It is not always obvious what the risks are by just looking at the surface of a portfolio,” Russell capital markets research director Geoff Warren said.

“When you look at a typical balanced portfolio, you tend to find between 85 and 90 per cent of assets are in equities, and we all know what has happened to equity markets.”

Warren said there were three types of mega risk that affect portfolios — the economy, earnings in the corporate sector and inflation.

“What is happening in the total economy will dictate what is happening in equity markets and can also affect fixed income as well,” he said.

“If the economy weakens, company returns are down and capital rates fall.”

Research undertaken by Russell using US rolling three-year returns versus gross domestic product (GDP) since 1929 shows there is correlation between the two.

If GDP growth is below 1 per cent equity returns are down by minus 4 per cent, and a typical 60/40 portfolio of equities and bonds would also achieve a negative return.

Alternatively, GDP growth of more than 6 per cent sees equity returns touch 12 per cent and a balanced portfolio would be up 6 per cent.

Again, corporate earnings tend to track the market index, although this has diverged in the past two years.

Russell looked at US corporate profit share versus real equity returns since 1950.

Generally, the two tracked together until the ‘dot com’ boom, which saw market returns way out of kilter with profit share.

In the past two years, profit share has roared ahead of the market.

Warren said the risk is the market may not have priced in the cyclical and structural components of corporate performance.

“The corporate sector is exposed to factors such as wages, government actions, debtors and cost inputs such as oil,” he said.

Factors affecting the economy will affect corporates, which is a mega risk to the portfolio.

The third mega risk, inflation, will again impact a portfolio, and looking at US inflation since 1875, Russell found returns change dramatically depending on inflation levels.

With inflation below 5 per cent, equities will achieve a return in excess of 10 per cent.

A balanced portfolio will achieve a return of about 10 per cent.

However, inflation of more than 9 per cent will deliver a minus 5 per cent return for equities and minus 6 per cent for a balanced portfolio.

“This is why equity markets are so concerned about inflation at present,” Warren said.

The solution for dealing with mega risks is to diversify the portfolio more.

Warren is recommends adding unlisted property, residential property, selected unlisted infrastructure, commodity futures and gold to a portfolio to spread the risk.

Property is seen as a hedge for inflation and profit share risks, Warren said, while commodities and gold protect against inflation risks.

“However, there are some issues with these strategies, such as the liquidity of unlisted trusts,” he said.

“At Russell, we believe illiquid investments should not be more than 25 per cent of a portfolio.

“But investors have won the trifecta for the last 25 years — the economy, profitability and inflation.

“The question is: can an investor be certain they will pick the same horses to win in the future?

“The answer is you can’t, which is why investors need to diversify.”