The conundrum of lower returns and greater risk
The conundrum of low returns sets up a desire to take on greater risks. Taking responsibility and lowering risk during times of poor expected returns makes sense, according to CheckRisk’s Nick Bullman.
Bonifacio in Corsica is a beautiful ancient town built high up on limestone cliffs, offering a safe haven to sailors by virtue of its deep inland waterway.
For centuries, sailors have sought refuge from the terrors of the Straits of Bonifacio where, during gales, the winds howl between the 14 kilometre stretch of the Island of Corsica and Sardinia.
In the middle of the Straits are rock outcrops known as the Île Lavezzi. It is against its reef, 500 metres offshore, that the ship the Sémillante ran aground in 1855 during a fierce storm.
The Sémillante had set sail from Toulon on 14 February 1855 bound for Odessa to supply troops and materials for the Crimean War.
On 15 February 1855, caught in the storm, the ship hit one of the few reefs marked by a buoy. The weather was atrocious and the visibility equally poor.
All 301 crew and 392 soldiers on board were lost. It remains the worst loss of life in a shipping disaster in Europe to this day.
The sinking of the Sémillante is more than just a marine tragedy. It is about risk and risk management. Why did Commandant Jugan decide to go through the Straits of Bonifacio, when a much safer route exists to the South of Sardinia and only adds a day at most to the route?
The winds that blew the Sémillante on to the reef off the Lavezzi would have favoured the southern route just as well.
It was mid-February and the weather had deteriorated as early as the afternoon of 14 February. Did the Commandant ignore these signs or was he aware of the risks? Could the watch on duty have spotted the marker buoy in time?
It may well be that Captain Jugan fell victim to behavioural risk factors. One of the most common accidents in transportation is known as “get there-it is” – the pressure of getting to one’s destination which forces pilots, sailors and drivers to finish their mission at any cost despite the risk.
Or, perhaps Commandant Jugan was lulled into a false sense of security by the size of his ship, one of only six in the French fleet of its size. He certainly underestimated the scale of the storm and became unaware of his position.
This is pertinent to investors. The larger the portfolio, the more secure the portfolio manager and/or investor may feel.
The more broadly diversified, the more safety – or so the line goes. However, that is only true if the passage navigated is safe. If comfort factors are used to increase the levels of accepted risk, then risk may increase exponentially.
It’s important to step back and focus on positional awareness – where we are right now in the risk picture. It is then for investors to decide whether they wish to take the longer, safer route or continue through treacherous waters.
For it is in these riskier waters that the Fed, Bank of Japan (BOJ) and Bank of England (BOE) are encouraging investors to navigate.
To quote Sophocles: “Truly to tell lies is not honourable, but when the truth entails tremendous ruin, to speak dishonourably is pardonable.”
Governments and government institutions around the world today are excusing themselves in the name of Sophocles.
It could not be more important for an investor today to be able to discern for themselves what is real and what is dishonourably pardonable.
The corrections of late May and early June – that CheckRisk forecast – have been brushed aside by investors as the S&P500 has hit new highs and many other equity markets globally approach their own. Equities are not alone.
Bonds, property, commodities, credit, and virtually every investible asset have experienced a massive bull market since the commencement of quantitative easing (QE) in 2009. Valuations have risen to levels that now imply low single digit returns for the foreseeable future.
As a risk, this represents one of the biggest challenges to portfolio managers looking to match assets with liabilities. The conundrum of low returns sets up a desire to take on greater risks – a classic case of “get there-itis”.
The risk of low returns is intensified by the way markets have been behaving. Most investors hold widely diversified portfolios.
This entails greater costs that run from administration to transaction fees and must be offset by enhanced performance to justify the cost. That performance enhancement may be generated by either outperformance or downside risk protection.
But there is a problem with diversification.
One of the main unintended consequences of low cash rates, and low forward rates is to drive up the price of all assets.
With low cash returns, investors have been forced to search for returns. That has resulted in the bidding up of investment grade credits to junk credits, and the search for dividend yields and real returns.
The net effect is to have removed negative correlations across the investment spectrum, thus rendering diversification a questionable and expensive tool.
We’re not saying that investors should abandon diversified portfolios.
However the logic for holding a diversified portfolio is not based, at present, on the benefit of non-correlation.
The reason for holding a diversified portfolio is that most investors cannot identify concentrated sources of return. The problem with non-diversified assets is you have to be right – you don’t get a second bite at the cherry.
Investors have a few options.
The first is to continue along the same path with widely diversified portfolios and to just believe in QE and the steady rise of assets ad infinitum.
That this sounds like the dumb approach is misleading because since 2009 it has provided excellent returns.
The issue now, as far as risk is concerned, is that as an approach it probably has had its day and will only deliver sub-par returns going forward.
The second approach is to abandon diversification and to focus on specific investments with superior returns – effectively, to concentrate the investment process on assets that are well understood. This approach will work for a few sophisticated, process-driven investors.
In our experience, investors such as these are few and far between.
A third approach is to recognise that diversification for the purpose of protection against negative correlation is simply not working.
Investors who agree with this conclusion are bound to make the next logical step – that is, to run less-diversified portfolios to reduce the costs of diversification, to hold larger than normal levels of cash in order to be able to buy value when it appears, to accept lower short-term returns for the benefit of the long run, and to use diversification as a means of spreading the risk of making a poor investment choice through over-concentration of a portfolio.
Those investors that are able to will also run option and futures overlay strategies.
It is this third approach that CheckRisk is recommending to medium– and long-term investors. Equity markets, indeed most asset classes, have had a very good run since 2009.
It is time to be starting to protect some of those gains with a cash and options approach.
Less diversification needs to be discussed – overseas investments carry the additional risk of exchange rates and the benefits of negative correlations are diluted at present by the low cash rate environment, thus concentrating risk across multi asset classes.
The Captain of the Sémillante may have been convinced of the invincibility of his mighty warship, confidant in his crew, seasoned in his ability to handle the weather, skilled at navigation and used to handling the pressure of superiors demanding a speedy result.
Yet, with all these skills, he failed to do the most important thing – to take responsibility and decide on the less risky option.
In an investment environment where returns are likely to be poor, with prices distorted by governments, a “new norm” of substandard economic growth, and with the benefits of diversification eroded, investors may wish to consider the less risky route.
Nick Bullman is founder of investment risk management research house, CheckRisk, available in Australia exclusively through PortfolioConstruction Forum www.PortfolioConstruction.com.au
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