May 2015
For professional investors only
Real Matters
Fear and Present Danger
David Wanis, Senior Analyst and Fund Manager,
Multi-Asset
We believe investors are facing a toxic combination of low returns, elevated risk and diminished diversification
opportunities. In environments like this, the probability of incurring a loss is rising for all portfolios - but most risky are those
portfolios constructed with seemingly limited regard for these growing market risks. In this paper we look at the recent
history and volatility of asset market returns, why we believe simple and robust valuation measures can assist in estimating
investors’ risk exposure, how investors respond (or fail to respond) to these changes in market conditions and compare the
characteristics of an alternative portfolio approach.
With risk best described by Elroy Dimson as “more things can happen than will happen” none of our analysis is meant as a
definitive prediction of the future. We do however think that in the (futile) pursuit of building crystal balls, investors often fail
to adequately understand the nature of the present – and the present we would describe as showing a lack of fear in the
face of a rising probability of danger.
Trying to be roughly right
Lessons from history tell us a few things about investing that seem to if not repeat, rhyme. Asset allocation as opposed to
security selection determines 90% of an investors’ return and risk outcome. Asset class investment returns vary greatly
through time - even if over the very long term they have tended to conform mostly to classic investor expectations.
Investors are influenced by behavioural factors more than the economic theory would suggest and extrapolation of recent
positive (and negative) experiences tends to anchor investor beliefs about the future.
To highlight some of these return variations Exhibit 1 shows four separate market regimes and our estimated and realised
(in the case of the first three) returns over the subsequent three years. Within our valuation process we take a 10 year
structural expected return forecast and then refine that for a time horizon that incorporates shorter term cyclical factors to
arrive at a three year estimate. The purpose of these charts is not to show any particular forecasting prowess or accuracy
(we ourselves are well aware of the magnitude of estimate error that comes with forecasting asset returns) - rather it is to
highlight that realised returns vary widely over this three year window. It is also useful to note that although the precision of
the return estimates is questionable the approximation of the expected return in a low, average or high range conforms to
the Keynesian objective of it being “better to be roughly right than precisely wrong”.
Exhibit 1: Estimated and realised three year returns – 2006, 2009, 2011 and 2015
Dec 2006
Mar 2009
25.0%
25.0%
20.0%
% per annum
% per annum
20.0%
15.0%
10.0%
5.0%
0.0%
15.0%
10.0%
5.0%
0.0%
-5.0%
Australian
US
Aust Govt US Govt Global
Equities Equities
Bonds
Bonds High Yield
Estimated 3yr Annual return
Realised 3yr annual return
-5.0%
Australian
Equities
US
Equities
Aust Govt
Bonds
Estimated 3yr Annual return
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US Govt
Global
Bonds High Yield
Realised 3yr annual return
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Dec 2011
Mar 2015
25.0%
20.0%
20.0%
% per annum
25.0%
% per annum
15.0%
10.0%
5.0%
15.0%
10.0%
5.0%
0.0%
0.0%
-5.0%
-5.0%
Australian
US
Aust Govt US Govt Global
Equities Equities
Bonds
Bonds High Yield
Estimated 3yr Annual return
Realised 3yr annual return
Australian
Equities
US
Equities
Aust Govt
Bonds
US Govt
Global
Bonds High Yield
Estimated 3yr Annual return
Source: Datastream, Schroders. Estimated return forecasts are nominal total expected returns over the three years subsequent to the forecast date. Realised
Returns are from Datastream
Expected returns in December 2006 were low for both U.S equities and credit whilst bond returns were reasonable (and far
lower risk). The subsequent equity experience was worse than forecast (indeed negative in the U.S), credit was better and
bonds performed largely as expected. In March 2009 after two years of negative equity returns and widening credit
spreads, the forward estimate had improved considerably - indeed looking far better prospectively than bonds. Although
both equity and credit markets performed well over the subsequent three years, the Australian market lagged the inhindsight optimistic forecast. Bond markets performed roughly in line with estimates and well behind equities and credit. In
December 2011 all return expectations had declined but there was still a clear preference for equities (expected 10-15%)
and credit (expected 6%) over bonds (expected 0 - 3%). Again in magnitude and preference this largely occurred although
equities delivered more like 15-20%, credit 8% and bonds 2-5% thanks to QE boosting returns.
Which brings us to today. Having done better than expected for the past six years, U.S equities, U.S government bonds,
Australian government bonds and credit have all borrowed from future returns and in aggregate present a poorer prospect
than in December 2006. The only market with a reasonable prospective return in this group - and even then a return below
its long term average - is Australian equities.
(Lack of) Fear
Due to aggressive global central bank policies we find ourselves today in unprecedented market conditions for the modern
investor. At face value asset returns have been healthy, volatility has been subdued and both sides of a diversified portfolio
have delivered admirably as strong returns in risk assets have not only been diversified by the duration of the defensive
portfolio investments but this side of the portfolio has more than carried its weight in contribution to returns. When looking
at the rising risk (probability of loss) in growth assets today we see a similar level of complacency (as referenced by the
‘fear index’ or VIX volatility measure below 15% per annum implied volatility) that was present in 2005 and 2006 (Exhibit
2). This is markedly different to the market in the late 1990’s when rising concern about growth asset risks was matched
with increased volatility. We continue to live in the Greenspan / Bernanke / Yellen ‘put’ era.
Risk presented here by reference to the probability of loss, is the probability based upon current expected return
(Schroders estimate) and the distribution of returns that over the next 12 months the realised return is less than zero.
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Exhibit 2: Investor Complacency - Growth asset risk vs VIX volatility
50
70
60
50
30
VIX
40
30
20
20
Probability of Loss (%)
40
10
10
0
0
VIX (LHS)
Growth Assets - Probability of Loss (RHS)
Source: Factset, Schroders. VIX data from Factset. Probability of loss is our estimated probability an asset delivers a negative return over the next 12 months.
Growth assets are the average of Australian Equities, Global Equities and Global High Yield
The last five years have been encouraging. However unless investors believe we are in a brave new world where central
banks have finally found the solution to risk in markets, then we have to consider that by borrowing returns from the future,
at some point tomorrow will come, and the investment experience will look very different to today’s.
The way in which central banks have achieved this through the bond market, provided duration benefits to portfolios today
but may have jeopardised the defensive role duration plays in tomorrow’s portfolio. Chasing real yields in defensive assets
down to extremely low levels has done wonders for recent capital returns. That is what central banks wanted and investors
have done - but the wrong price can turn a safe series of cash flows into a risky investment.
In prior cycles, when risk - say probability of loss - for growth assets was high (1996-2000, 2006-07) the risk in defensive
assets was low. Investors who followed an active approach to asset allocation and sought to minimise the risk of capital
losses could move to the defensive asset for both capital protection, and some level of real return until the opportunity in
the growth asset became more attractive. We show this in Exhibit 3 using the primary global growth and defensive assets U.S equities and U.S government bonds. Indeed even the fixed Strategic Asset Allocation (SAA) investor could rely on
defensive asset allocations to dampen overall portfolio volatility and limit growth asset losses.
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Exhibit 3: Probability of Loss - U.S equities vs U.S Gov’t bonds
80.0
Probability of Loss (%)
70.0
60.0
50.0
40.0
30.0
20.0
10.0
?
0.0
U.S Equities
U.S Gov't Bonds
Source: Schroders. Dec 1989 – Mar 2015. Probability of a negative return in the next 12 months
Exhibit 4: Probability of Loss - Aust. Equities, Aust. Gov’t bonds and Credit (Global High
Yield)
60.0
Probability of Loss (%)
50.0
40.0
30.0
20.0
10.0
0.0
Australian Equities
Australian Govt Bonds
Global High Yield
Source: Schroders. Dec 1989 – Mar 2015. Probability of a negative return in the next 12 months
Cash can also serve the role of the defensive asset with a zero probability of loss in Australia, if not Europe. However most
investors rely on the historical equity / bond asset correlations and allocate to bonds to provide a positive capital return in
times of stress.
Today investors are faced with a very different set of choices. Strong performance of growth assets - performance well in
excess of long term expected returns - has led to a rising risk of loss, yet the central bank influenced performance of
defensive assets (a.k.a financial repression), has resulted in a level of loss probability as high if not higher than that of
equities. Granted the magnitude of losses from defensive assets is likely to be smaller, however that will be small
consolation for investors holding a portfolio of growth and defensive assets with the objective of diversification based
capital protection.
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The reasonable valuation of Australian equities makes the risk to the domestic growth asset less of an issue over a longer
horizon, however, we cannot escape the near term effects of a U.S equity market under stress and the high correlation of
domestic growth assets to this scenario.
We think there are choices investors should consider under present market conditions: continue with their relatively static
allocation to the growth and defensive asset portfolio – reflecting concerns through tactical asset allocation positions – but
be prepared for outcomes that may be dramatically different not only to what they have experienced over the past five
years, but also experienced in prior market cycles. Alternatively investors can relax their asset allocation constraints and
work with views on likely (probability based) return and risk outcomes to implement an objective based asset allocation
strategy most likely to realise investor objectives over the long term.
Within these choices there are of course a range of implementation alternatives - including more aggressive tactical asset
allocation and/or adding complexity and cost to the SAA model in the hope that unlisted assets, private equity, hedge
funds or tail risk hedges or any other strategy can do enough (after fees) to overcome the embedded market risks.
The role of cash
Nothing in an investors’ portfolio seems to attract attention like cash holdings, whether it’s an equity portfolio manager’s
decision to increase cash weight in the face of poor stock prospects, a bond manager building up cash because accepting
duration risk looks unpalatable, or at the asset allocation level for a portfolio to hold high levels of cash in order to protect
against a combination of these risks.
For those with a long time horizon the observation by Warren Buffett that “cash is a call option with no expiration date or
strike price” means that when faced with insufficient returns in the current market, cash provides a call option on higher
future returns when they present themselves. In holding cash we profess no accuracy into the timing of when these
opportunities may occur but desire an option over them in order to meet our longer term objectives of both return and risk.
The Present Dangers
Ultimately there are two risks investors assume. Firstly there is the risk inherent in the structure of the asset they purchase.
The second and arguably more important is market risk – related to point in time market based characteristics of the asset
such as valuation and liquidity, geopolitics, macroeconomics and monetary policy. Given the structural risks are so
observable and largely diversifiable, true risk tends to reside in the market component.
Investors wanting to shift their asset allocation in line with changing market based risks cannot escape formulating views to
inform the allocation of the portfolio. Exhibit 5 summarises our views - expected annual returns over the next three years
against an estimate of downside risk for each asset. This is different to the risk we discussed previously as the probability
of loss as the downside risk estimate also concerns itself with how much may be lost.
This downside risk is expressed as a forward looking measure of how much an investor would likely lose on average in the
worst year in twenty given the current starting valuation. For example U.S equities starting from a 2% expected return
could lose almost 40% of their value one in every twenty years. This is technically known as the 95% Conditional Value at
Risk (95% CVaR) or as we prefer in English, Potential Downside Loss – although in our implementation a significant
difference is that our calculation is based upon our forward looking estimate of risk rather than relying solely on historic,
statistical calculations.
No single measure of risk is perfect (and nor is this one) however this view of risk captures a few characteristics we think
investors care about;
1.
It encapsulates the shape and magnitude of investment return distributions – usually represented by a
single number called volatility
2.
As importantly it captures the left tail downside risk particular to each asset – in other words on the rare
occasion something really bad happens – how bad will it be?
3.
It reflects the view that volatility per se is not risk, rather losing money is risk – and although the two
concepts are tangentially related they are not the same thing
4.
It recognises that investors assume two risks – the asset characteristic risk and the market risk. The
lower the prospective return of an asset – all other things being equal – the higher the risk of that
investment when risk is defined as losing money
5.
It visually depicts the capital market line as upward sloping from left to right in the same manner as the
traditional return vs volatility charts.
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Exhibit 5: Expected Return vs Potential Downside Loss – March 2015
10.0%
Aus. Equities
8.0%
3yr Expected Return Est.
UK Equities
EM Equities (H)
6.0%
EM Bonds
4.0%
2.0%
Euro Equities
US Equities
Aus. Gov't Bonds
0.0%
Global Equities (H)
Aus. High Yield
Aus. Cash
Aus. IG Credit
Global High Yield (H)
Japan Equities
Euro IG Credit
Japanese Gov't Bonds
UK Gov't Bonds US Gov't Bonds
German Gov't Bonds
French Gov't Bonds
-2.0%
-4.0%
10.0%
US IG Credit
0.0%
-10.0%
-20.0%
-30.0%
A-REITs
-40.0%
-50.0%
-60.0%
Potential Downside Loss (95% CVaR)
Source: Schroders
To pick out a couple of data points to understand how value and tail risk interplay we can first look at Australian equities
and U.S equities. Both have similar characteristics (long term return volatility, skew and kurtosis) and using volatility would
indicate a similar level of risk. However our return vs potential downside loss chart incorporates the view that low expected
returns have amplified the risk that investors care most about – losing money – in U.S equities. Secondly if we compare
Australian equities with Emerging Market (EM) equities we can see that despite having a similar level of expected return
the volatility and distribution of EM returns carry significantly greater risk. The final observation is that even though
European government bonds have the worst expected returns and a probability of realising an annual loss in the next three
years of over 60% the distribution of these returns from such a negative starting point is such that the tail risk is still smaller
than for equity or diversified assets.
All the returns presented in this chart are our own estimates and it quickly becomes apparent that outside of Australian, UK
and Emerging Market equities, there are no assets offering a 5% per annum nominal expected return over the next three
years and most assets are priced to return somewhere between -1% and +3% per annum. However markets do not move
in straight lines and in equities for example a 1% per annum return over three years is much more likely to be delivered as
+5%, -15%, +15% or -5%, +20%, -10% than it is +1%, +1%, +1%. A typical investment strategy may look to
simultaneously target a return objective such as CPI + 5%, do so over reasonable time frames such as rolling three year
periods and be mindful of the path of returns and drawdown risk. In balancing these at times competing targets there are
market environments when prioritizing controlling risk and preserving capital allow the portfolio to exploit opportunities that
the market presents after periods of volatility and disruption. Fixing asset allocation in the face of low returns reduces the
ability to take advantage of the non-linear path that history tells us returns take, to improve our return and risk outcomes.
Portfolio Implications
We believe investors are facing a toxic combination of low returns, elevated risk and diminished diversification
opportunities. In environments like this, the probability of incurring a loss is rising for all portfolios. That said, having
experienced a dramatic range of investment returns across all asset classes, investors continue to largely fix their asset
allocation.
By their own investment choices investors cannot escape active decisions about their portfolio - whether it is at the asset
allocation level (conservative, growth, aggressive, objective based) or security selection level (active, passive) in their
choice of what they define as assets (hedge funds, private equity, venture capital, infrastructure, property) and in the fees
they choose to incur to implement their portfolio. Yet for many investors the determinant of 90% of their return and risk
outcome appears to be fixed under a mostly stable SAA framework (Exhibit 6) and a great weight is placed upon the other
factors to achieve their longer term investment objectives. Arguably after fees, asset allocation decisions are where
investors can have the greatest influence on the probability of realising these objectives or assume time heals all wounds –
not necessarily true from a money weighted perspective.
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Exhibit 6: Default (Growth) Portfolio asset allocation history
100%
8.0%
5.9%
6.2%
6.7%
6.0%
5.7%
7.5%
8.7%
21.4%
22.6%
20.2%
20.2%
20.3%
19.5%
19.8%
20.8%
74.3%
70.6%
71.5%
73.6%
73.0%
73.6%
74.7%
72.8%
70.6%
Dec-06
Dec-07
Dec-08
Dec-09
Dec-10
Dec-11
Dec-12
Dec-13
Dec-14
8.1%
6.7%
6.0%
18.5%
19.8%
19.7%
73.5%
73.5%
Dec-04
Dec-05
90%
80%
70%
60%
50%
40%
30%
20%
10%
0%
Cash
Defensive
Growth
Source: Morningstar Multi Sector Growth - Asset Allocation Survey
To illustrate this we examine a standard growth portfolio and assess how the risks of that portfolio have morphed over the
past decade. We use the same probability of loss tools highlighted earlier and construct a simple average of the growth
and defensive assets determined by SAA weights without going into the benefits that may be added from correlation
between the assets being less than one. We acknowledge that this is a simple calculation but is done to highlight
embedded valuation and capital loss risks in a portfolio without the extra layer of assumptions correlations bring. Using a
decade of Morningstar asset allocation and Schroder Investment Management return and risk estimate data, we provide
an approximate (and pre benefits of correlation) estimate of the probability of loss of the average growth portfolio in Exhibit
7. This is a reflection of the individual risks we highlighted earlier seen from an overall portfolio perspective. While the
overall portfolio risk is not quite as elevated as December 2007, it is climbing to the higher end of the historic experience.
Exhibit 7: Portfolio probability of loss (pre correlation benefit) 2004 - 2014
40%
Probability of Loss (pre correlation)
35%
30%
25%
20%
15%
10%
5%
0%
Dec-04
Dec-05
Dec-06
Dec-07
Dec-08
Morningstar Aus Msec Growth Probability of Loss
Dec-09
Dec-10
Dec-11
Dec-12
Dec-13
Dec-14
Schroder Obj Based RRF Simple Probability of Loss
Source: Schroders Estimates
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Investor choice and trade-offs
The market will only offer investors so much return and reaching for higher returns may just result in unacceptable risk –
the risk that the longer term objectives are not met. Sometimes the protection of capital when risk and return are
unappetizing allows an investor the future opportunity to invest when risk premiums have been restored and prospective
returns look healthier.
The final analysis we perform then is to optimise two portfolios using our asset returns and risk estimates to determine
what sort of portfolios investors might hold to achieve two different outcomes;
1.
A return focused portfolio that looks to achieve a target return of CPI + 5% - labelled Target Return Model
on Exhibits 8 and 9
2.
A risk focused portfolio that looks to limit the probability of loss to 5% and protect capital and allow for
the optionality of reinvestment – labelled Capital Protection Model on Exhibits 8 and 9.
Unlike the simple growth portfolio probability of loss chart, this optimisation does take into account full diversification
benefits from estimated correlations between assets. Given our modest return forecasts across assets however investors
cannot escape the reality of few assets providing a CPI + 5% type return – and those that do bring considerable risk to a
portfolio. Indeed the target return model holds over 80% of its portfolio in a single asset (Australian equities) which creates
a concentration risk that many investors may find unacceptable. The 5% probability of loss portfolio sacrifices not
insignificant return however also dramatically improves the downside risk exposure of the portfolio. There are of course
portfolios on a frontier between these two book ends and ultimately investors need to determine where on this risk return
spectrum they are comfortable.
Given the current market environment we would favour a portfolio at the Capital Protection Model end of the spectrum as
the risk attached to reaching for a Target return is at historically elevated levels.
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Exhibit 8: Probability of loss of sample portfolios optimized to a return and risk objective
10.0%
9.0%
Expected Return
8.0%
7.0%
Target Return
Model
6.0%
5.0%
4.0%
Capital Protection
Model
3.0%
2.0%
1.0%
0.0%
0%
5%
10%
15%
20%
25%
Probability of Loss
Source: Schroders. Target Return Model AA is 81% Growth, 10% Defensive, 9% Cash. Capital Protection Model AA is 19% Growth, 37% defensive, 44%
cash
Exhibit 9: Downside risk of sample portfolios optimized to a return and risk objective
10.0%
9.0%
Expected Return
8.0%
7.0%
Target Return
Model
6.0%
5.0%
4.0%
Capital Protection
Model
3.0%
2.0%
1.0%
0.0%
0%
-2%
-4%
-6%
-8%
-10%
-12%
-14%
-16%
-18%
Potential Downside Loss (95% CVaR)
Source: Schroders. Target Return Model AA is 81% Growth, 10% Defensive, 9% Cash. Capital Protection Model AA is 19% Growth, 37% defensive, 44%
cash
What would we do?
Exhibit 10 provides a counterpoint to an SAA approach which is the actual asset allocations implemented by an objective
based asset allocation strategy (the Schroder Real Return CPI + 5% fund). This highlights how the rising risks to first
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growth and then defensive assets result in a meaningful active change in asset allocation as the fund reacts to the market
environment and looks to preserve the probability of achieving its longer term objectives.
The entire purpose behind this analysis is to improve the probability investors meet their long term investment objectives.
One way of visualizing this is represented in Exhibit 11 where we look at the frequency of three year returns above and
below a CPI + 5% investment objective. By adjusting asset allocation to the prevailing market opportunities we try to
narrow the distribution of outcomes around the investment objective (in this case CPI + 5%) and increase the probability
that this objective is achieved. We purposefully give up both extreme investment outcomes resulting from a fixed SAA
model in exchange for an increased probability of achieving the objective across most time periods.
Exhibit 10: Schroders objective based Real Return Fund asset allocation since inception
100%
17.4%
90%
18.9%
19.9%
22.6%
80%
22.1%
70%
24.6%
31.5%
25.5%
28.7%
40.3%
39.9%
Dec-12
Dec-13
34.6%
25.5%
35.6%
60%
34.3%
50%
30.8%
40%
60.5%
30%
56.5%
51.9%
44.5%
20%
34.6%
10%
0%
Dec-04
Dec-05
Dec-06
Dec-07
Dec-08
Cash
Dec-09
Dec-10
Dec-11
Defensive
Dec-14
Growth
Source: Schroders. Inception Date October 2008
Exhibit 11: Distribution of returns against objective – Objective Based vs Fixed SAA
50%
Real Return
Target: 5% p.a.
Historical Probability
40%
30%
20%
10%
0%
Less
than
0%
0% to
1%
1% to
2%
2% to
3%
3% to
4%
4% to
5%
5% to
6%
6% to
7%
7% to
8%
8% to
9%
9% to 10% to 11% to 12% to Greater
10%
11%
12%
13%
than
13%
Real Return (p.a.) over Rolling 3 Year Periods
Real Return CPI + 5%
Morningstar Aus Msec Growth TR AUD
Source: Schroders. Pre fee returns for both series: from Oct 2008 (Schroder Real Return CPI + 5% Inception date) to March 2015.
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Closing thoughts
It is often after a period of low risk (high returns, limited losses) that investors start to question the value of risk
management. As markets continue to deliver consistent and abundant returns, anything left on the table in the name of
prudence comes under scrutiny. As the passive alternatives - either at the stock selection or asset allocation level - gain
increasing exposure to momentum any philosophy that believes trees cannot grow to the sky (value based, contrarian) will
almost by definition be left behind.
It is a great irony for those who experienced 2007- 2009 that we are in the position we are today. Re-leveraging, reaching
for yield, feeling angst at investing with one eye on risk because of the points left on the table. The most extreme equity
valuations observed for the least proven enterprises. Narrow spreads for the most risky of debts – made riskier by financial
engineering. Risk appetite driven to off the chart levels, underwritten by confidence in the ability of central banks to
suppress volatility and propelled by investor concerns over ‘peer’ risk all leading to a market absent fear.
Asset allocation remains one of the most effective tools available in reaching investors’ objectives however in the face of a
hostile investment environment across most assets we believe many investors would benefit from considering alternative
approaches to a fixed allocation model when it matters most – before something unexpected and potentially unpleasant
happens.
Important Information:
For professional investors only. Not suitable for retail clients.
Opinions, estimates and projections in this article constitute the current judgement of the author as of the date of this article. They do not necessarily reflect
the opinions of Schroder Investment Management Australia Limited, ABN 22 000 443 274, AFS Licence 226473 ("Schroders") or any member of the
Schroders Group and are subject to change without notice. In preparing this document, we have relied upon and assumed, without independent verification,
the accuracy and completeness of all information available from public sources or which was otherwise reviewed by us. Schroders does not give any
warranty as to the accuracy, reliability or completeness of information which is contained in this article. Except insofar as liability under any statute cannot be
excluded, Schroders and its directors, employees, consultants or any company in the Schroders Group do not accept any liability (whether arising in contract,
in tort or negligence or otherwise) for any error or omission in this article or for any resulting loss or damage (whether direct, indirect, consequential or
otherwise) suffered by the recipient of this article or any other person. This document does not contain, and should not be relied on as containing any
investment, accounting, legal or tax advice.
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