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 article we look at the recent
asset risk and volatility trends, 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.
(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
1). 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.
Exhibit 1: 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
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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.
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 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.
To illustrate current risk 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 concept highlighted earlier and construct a simple average of
the growth and defensive assets determined by the relatively stable asset allocation weights of the average Morningstar
Australian Multi Sector Growth portfolio 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 Schroders’ 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 2. 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 2: 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: Morningstar data, Schroders Estimates
What would we do?
Exhibit 3 provides a counterpoint to a stable strategic asset allocation (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 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.
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.
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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 4 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 3: Schroders objective based Real Return Fund asset allocation since inception
100%
90%
17.4%
18.9%
19.9%
22.6%
80%
70%
22.1%
24.6%
35.6%
60%
34.3%
31.5%
25.5%
28.7%
40.3%
39.9%
34.6%
25.5%
50%
30.8%
40%
30%
60.5%
56.5%
44.5%
20%
51.9%
34.6%
10%
0%
Dec-08
Dec-09
Dec-10
Cash
Dec-11
Dec-12
Defensive
Dec-13
Dec-14
Growth
Source: Schroders. Inception Date October 2008
Exhibit 4: 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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