The danger of simplifying Australian equities
Rudi Minbatiwala looks at the challenges of objectives-based strategies and the drawbacks associated with the simplifications of the risk concept.
In recent years, the funds management industry has begun to focus more significantly on the unique challenges related to constructing and managing retirement portfolios.
The development of advice/consulting frameworks that holistically assess investors’ requirements that incorporate financial goals, changing risk preferences, lifestyle needs and the management of capital draw-downs is being actively debated and considered by asset managers.
In response to this perceived need, the concept of tailored investment strategies, or objectives-based strategies, is getting increased airplay as attempts to address these issues.
Undoubtedly, the level of complexity when it comes to constructing appropriate investment strategies for retirees has increased.
Despite this, the investment world is prevalent with the use of rules of thumb and simplifications. However, simplifications often adopted in Australian equity strategies may ultimately result in portfolios that do not achieve what they have been designed to do – the very objective they are designed to meet.
The challenge of multiple objectives
The complexity of formulating appropriate investment strategies in an outcomes-based world comes from the fact that the number of issues and objectives to be considered increases significantly as investors approach retirement. These include, but are not limited to:
- generating a sustainable income stream from investments;
- maintaining the purchasing power of the accumulated wealth to meet the desired lifestyle;
- longevity risk management;
- estate planning considerations; and
- constraining investment strategies to match the increased risk aversion for these investors.
These objectives and challenges are further complicated by the different time-frames for each investment objective.
For example, income requirements are a short-term objective, whereas inflation risk management is a long-term issue.
Addressing these various considerations concurrently will typically require the implementation of a combination of investment and insurance strategies.
For the investment component, asset allocation has always been a key consideration when designing a strategy to match the risk profile or objectives of an investor.
This asset allocation solution has not only been relatively simple to implement but, importantly, the asset allocation concept has been also relatively simple and understandable for the end investor, the client.
The increasing risk aversion and requirement for an income stream as investors progress from the accumulation phase, through the transition phase and into the retirement phase, is well documented.
Conceptually, this has been addressed by increasing the allocation to traditional income asset classes such as bonds and cash.
However, in the current market environment, the expected returns from traditional income asset classes are low due to the global yield compression that has occurred in recent years.
As a result, the current level of income being produced is below long-term expectations and it is difficult to generate sufficient levels of current income to meet investor needs.
Further, there are concerns regarding government and central bank intervention, possible bubbles in bond markets, and compressed credit spreads that may result in potential losses as the yield compression unwinds at some stage in the future.
It is increasingly clear that asset allocation alone will be insufficient to address investors’ requirements in an outcomes-based world. One commonly referenced outcome is the need for certainty of sufficient income.
If a greater emphasis is placed on certainty, the absolute level of income is likely to be too low. If, on the other hand, the greater emphasis is on sufficiency, the level of risk undertaken to achieve this may be too high. Given the immediacy of the need for current income, two alternatives are available:
- Increase the rate of capital draw-down, at the expense of sacrificing future income and returns; or
- Seek alternative sources of higher returns/yield, at the expense of greater risk.
As a result, there remains a prominent role for allocations to equities in an outcome-based investment strategy, as investors have increasingly looked to growth assets to meet their income requirements.
While the case for using equities to provide income is sound, the primary source of complexity in developing an equities strategy for an outcomes-based world is the inter-related and often conflicting objectives between the return composition, return path and return that need to be addressed.
This is, of course, not easy to resolve – and the end result can be an investment strategy that appears to address the desired outcomes over a shorter time-frame but may not address some or all of the objectives as originally intended over the long term.
Simplicity of the risk concept
Most investors today recognise the long-term benefits of investing in equities.
They expect to earn a higher return than most other asset classes, on average, over time. Investors are also aware that they take on additional risk.
While the return concept is well defined and understood, the concept of risk is intangible and defined ambiguously, in part because it is not something easily observed even when looking in the rear view mirror.
Risk is the exposure to a particular potential loss. If the loss does not ultimately eventuate, the exposure to that risk cannot be readily measured ex-post.
The most popular and enduring definition of risk remains volatility, so much so that these two terms are used interchangeably.
Many investors only think about risk as volatility, or the standard deviation of investment returns.
This is simply a measure of how far returns might deviate from the average – an investment with high volatility is thought to be risky because one might end up with a (large) negative return even when everything was expected to be okay.
That volatility equals risk is a concept ingrained in popular investment thinking since it was first introduced in Markowitz’s Modern Portfolio Theory in 1952.
For traditional investment strategies that are based on a long-term strategic asset allocation framework, the use of volatility as a measure of risk may be sufficient.
These investment strategies are focused on long-term wealth creation, and the volatility measure will provide an indication of the range of possible outcomes and the frequency and magnitude of negative returns between the end points of the investment time horizon.
The long time frame also means that the embedded simplification that the underlying range of return outcomes follows a bell curve, or normal distribution, is widely accepted by investors when undertaking mean-variance optimisation and blending to construct model portfolios.
This simplification has its drawbacks, however, particularly in the context of equity strategies for outcomes-based investing.
In this context, the concept of risk needs to be even more broadly defined to encompass the risk of not achieving the intended objectives.
As a result, rather than just assessing the cross-sectional volatility of equities over a given time horizon, the time series or path of the return from equities also needs to be assessed.
This is because the investor’s outcome will be a function of both the investment returns achieved and the investor’s rate of contributions or draw-downs.
There is a need to consider risk in two dimensions.
Understanding this concept of path dependency highlights a number of additional limitations in relation to simply using a mean-variance optimisation approach to construct model portfolios for outcomes-based investors.
These limitations are in addition to the well-known issues relating to the sensitivity of inputs and assuming stable correlations between assets.
Firstly, the optimisation is based upon assuming a single period framework for the investment horizon. This ignores the time/path dependency discussed above and cannot account for the timing and magnitude of cashflows, which are important factors for outcomes-based strategies.
Secondly, the composition of returns between income and capital growth cannot be assessed. This is an important consideration for many investors who require a sustainable income stream from their investments.
Thirdly, outcomes-based investment strategies are likely to have larger allocations to non-normal asset classes or non-static variable beta strategies, both of which cannot be easily accurately modelled for the optimisation.
Holistic assessment required
In assessing the appropriateness of solutions for retirement savings and post-retirement investors, a holistic assessment of risk that understands the applications and limitations of different risk metrics is essential.
Simply relying on traditional metrics such as volatility is insufficient.
An allocation to Australian equity strategies within an outcomes-based framework must consider not just the journey risk produced by the frequency and magnitude of negative returns but also the path risk as the investment outcomes interconnect with the cashflow requirements of the investor.
Rudi Minbatiwala is a senior portfolio manager, Australian Equities, Core at Colonial First State Global Asset Management.
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