Tailoring exposures for Australian investors

Australians have sought offshore diversification for years. The logical extension is to think more deeply about how to make offshore exposures complement local ones, according to Perpetual’s Michael Blayney. 

Australian-based investors managing multi-asset class portfolios have a number of advantages, most notably a cash rate above the rate of inflation.

Investors face a number of challenges in the current market environment, including high equity market volatility, macro uncertainty and the impact of deleveraging.

At the same time, investors are looking for downside risk management and, in many cases, they also still need to aim for relatively high CPI+ returns in order to meet their objectives.

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While this is true of all investors, it is particularly acute for those getting closer to retirement, and for those in the post-retirement phase.  

Investors generally want the following from their investments: 

• Earn a return of inflation plus 3 per cent to 5 per cent per annum; 
• Limit the downside / improve the journey; and, 
• A stable income stream in retirement. 

How much focus on risk vs return? 

While there is much talk in the industry about risk management, the reality is that the primary focus remains on returns.

Historic returns and surveys of returns are highlighted in the media and by fund managers in their marketing material.

While many of the leading performance and analytics software packages allow surveys of risk to be produced under a range of metrics – and have done for many years – it remains that little attention is paid to comparing the risk levels adopted by funds or their managers to achieve the published results. 

This is rational given the majority of investors have been in the accumulation phase for the past few decades, but becomes less defensible as investors increasingly need to draw down on their capital for living expenses.

The following analysis uses a very simple measure of risk – volatility (or standard deviation) of returns. This is, of course, an imperfect and much criticised measure of risk, but it is widely used and its simplicity and objectivity make it suitable for a simple illustration. 

An investor with a low existing balance, but a lot of future contributions has a very different cash flow profile from a retiree who is drawing down on their balance or, indeed, an older investor nearing retirement. 

Consider two different investment strategies: 

• The first strategy is simply a typical balanced fund, with 30 per cent Australian equities, 25 per cent global equities, 10 per cent unlisted property, 10 per cent unlisted infrastructure, 20 per cent fixed interest and 5 per cent cash. The inclusion of both unlisted property and infrastructure means that this balanced fund starts with 20 per cent in illiquid (or alternative) assets, so is already well diversified by industry standards. 
• The second strategy invests one third in this traditional balanced fund and one third in each of two hypothetical, non-traditional multi-asset class strategies. 

The return per annum for the second strategy is higher than the first. In order to remove this impact (and so compare only the impact of lower volatility), the last 36 monthly returns are normalised – that is, a small amount is deducted from each monthly return, so that the per annum return for the two strategies is identical. 

The resulting absolute levels of volatility are not dramatically different – the multiple strategies portfolio has a volatility of 6.4 per cent per annum compared to the balanced fund with a volatility of 7.1 per cent per annum. 

Accumulation phase 

Assume the accumulator investor starts with a zero balance at the same date and contributes $6,000 per annum, also indexed at 3 per cent per annum. 

In the early accumulation phase, volatility makes little difference to the accumulator investor and, in fact, (in this illustration) works to the investor’s advantage.

From a starting initial account balance of zero at 1 January 2000, the balanced portfolio grows to around $130,000 by 1 May 2012, while the multiple strategies portfolio reaches just over $120,000.

This is because, from a zero balance, dollar cost averaging is a sensible strategy to manage market volatility.

In this early accumulation phase, total returns matter most and risk is very much a secondary consideration, as most of the value of the investors’ portfolio is really the unobservable present value of future contributions. 

Drawdown phase 

Now assume a retiree is drawing down an income of $40,000 per annum (indexed at 3 per cent per annum) from a portfolio with a starting balance of $450,000 as at 31 December 1999. 

In drawdown phase, despite the return series being identical (by design), the lower volatility, more diverse multiple strategies portfolio results in the investor having significantly more remaining in their account balance at the end of the period.

From an identical starting balance of $450,000 at 31 December 1999, the balanced portfolio has a balance of just under $100,000 by 1 May 2012 while the multiple strategies portfolio has a balance of $150,000. 

This is simply a result of being a forced seller into volatile markets – the lower volatility strategy does a better job of managing these drawdowns and so the need to earn subsequently higher returns to recoup losses is lessened.  

This is clearly a simple example – however, the key point is that the pattern of cash flows for the end user is an important consideration in setting an investment strategy.

In the example, it is achieved through more diversification and a modest improvement in volatility. 

Given that Australia’s superannuation system is maturing and its population aging, an increasing number of investors will have a profile much closer to that of the drawdown example.

However, for many investors, a simple de-risking to cash and bonds will not be a sensible strategy, as longevity risk will then dominate. High real returns will still be needed to manage longevity risk. 

We therefore turn our attention to some ways that investors can better manage risk, but within the framework of a strategy that is still return seeking. 

The unbalanced default strategy 

The primary way in which most investors seek to mitigate risk is via diversification - both between and within asset classes.

A logical starting point is therefore to examine how diversified existing portfolios actually are. Figure 1 illustrates a typical 70/30 asset allocation, which has become the industry default strategy.

Here, the equities component is not shown by geography (as is typical industry practice), but instead by broad sector grouping. 

In spite of the fact that the productive global economy is made up of a number of sector groupings that are very investible from a traded markets perspective (broadly, under the GICS classification: technology, materials, energy, utilities, consumer staples, consumer discretionary, telecommunications, financials, health care and industrials), investors have around 20 per cent of their portfolios in financial stocks, with another large slice (cash and fixed interest) also very exposed to financials.

This represents a large, and unnecessary, concentration of risk. 

The reason for this is, of course, the home bias of Australian investors, combined with the concentrated local sharemarket.

Figure 2 illustrates the sector breakdown of the S&P/ASX200 Index, the MSCI World ex-Australia Index, and the MSCI Emerging Markets Index, based on GICS classifications.

It is reasonably obvious that Australia has a few key biases – a massive allocation to financials, and a very large allocation to resources. 

Australian investors diversify their equities by investing into global developed and emerging markets. There is, however, only a limited opportunity set in emerging markets to diversify these biases, given the large weighting to financials and resources within emerging markets. 

As a result, it is logical to construct the developed markets equity portfolio differently – with a larger focus on defensive sectors not well represented domestically, such as health care, telecommunications, utilities and consumer staples.  

It is also logical to hold less financials, given how heavily exposed Australian investors already are to this sector.

This helps to reduce the cyclical bias in the overall equities portfolio. It also has the added benefit of cushioning returns in down markets, while still providing scope for some modest outperformance of the simple market cap weighted index in the long run, due to the benefit of regular rebalancing of sector allocations. 

A simple example of an alternative portfolio construction follows in Figure 3. 

By modifying the global equities benchmark in this way, a lower correlation to Australian equities can be achieved – for example, the rolling three-year correlation to Australian equities at 31 December 2012 was just under 0.4 for the MSCI World ex-Australia index vs around .23 for the tailored portfolio. 

Clearly, this would require a departure from the industry norm of managing to (or against) a market capitalisation-weighted benchmark for global equities. However, given the obvious improved diversification potential, this is something investors should consider. 

Impact of currency as a diversifier 

Aside from industry exposure, another key issue for Australian investors in offshore investing is currency.

Historically, the Australian dollar has had a “risk on” status, meaning that it has tended to fall in times of crisis.

Furthermore, because of the strong resource bias in the Australian economy, it also has a factor risk in common with emerging markets. 

Indeed, over the period from 31 December 1996 to 30 June 2013, in months where Australian equities returned -3 per cent or worse, the median performance of foreign currency exposure was +2.1 per cent, and was positive 72 per cent of the time. 

Investors have historically earned a risk premium for holding Australian currency. This is evidenced by Australia’s consistently higher real cash rate than most other developed economies, which then flows through to higher returns for a hedged benchmark than a simple local currency benchmark (around 2 per cent per annum). 

This has a few important implications: 

• For many investors in Australia, foreign exchange exposure will be desirable from a portfolio diversification perspective; 
• Australian investors need to be cognisant not just of the level of the exchange rate, but also expected future interest rate differentials when making a trade-off between hedging and not hedging offshore portfolio exposures; and, 
• It is important, when considering offshore exposures, to view them through the lens of an Australian dollar-based (AUD) investor. Simply extrapolating research done in US dollars (USD) can lead to quite erroneous conclusions. 

One stark example of the last point is local currency emerging market debt (EMD-LC). From the perspective of a USD investor, EMD-LC behaves as a risk asset, with (as shown in Figure 4) relatively high volatility of 11.8 per cent per annum and quite a high correlation to equity risk. 

For an Australian dollar-based investor, the picture is very different, with the volatility being much lower and correlation to equities actually slightly negative. 

As local currency sovereign debt currently provides a yield pick-up relative to Australian government bonds of around 3.5 per cent, an Australian based investor can, perhaps surprisingly, view the allocation as a risk neutral portfolio exposure. 

There is also the added benefit of providing some non-AUD exposure in a portfolio, but without the negative carry associated with holding a lot of developed market FX exposure. 

Commodity futures 

Another form of offshore exposure, commodity futures, is an asset class not broadly used by Australian investors, but one with some diversifying and inflation hedging characteristics, and one where the way in which currency is managed and the basket is constructed has significant implications for portfolio diversification. 

Seeking diversification from commodities 

Since the early 2000s, commodity futures have been an asset class gaining increasing allocations from investors, with assets invested growing rapidly (albeit from a very low base). The typical reasons given in support of an investment in commodity futures are: 

• A historic risk premium that is similar to equities (albeit with volatility also similar to equities); 
• A low to negative correlation with equities and bonds; 
• Protection against an unanticipated spike in inflation; and, 
• Protection against macroeconomic event risk (for example, a war in the Middle East, a spike in food prices in emerging markets, deliberate debasement of major currencies). 

The main argument against an allocation is the very fact of increased financial investment. 

A typical commodities benchmark is composed of energy, industrial metals, precious metals, livestock and agriculture. The vast majority of Australian investors do not have an allocation to commodity futures primarily due to a belief that they are already very exposed to commodity price risk via the Australian share market. 

This is, of course, correct, although the commodity exposure from the Australian equity market is mostly industrial metals, with some energy. A bottom-up analysis of sales for the S&P/ASX50 yields the exposures shown in Figure 5 (grouped using the classifications typically used in commodity indices). 

The key points from this are: 

• Revenue from commodities does represent a large proportion of ASX50 total revenues; 
• The breakdown of the basket is however very different to a typical commodity futures index. A large proportion of the commodities in the ASX50 basket are not represented in the commodity futures indices (Coal, Iron Ore) and tend to be based around a contracted price.
  The large industrial metals exposure in the ASX does potentially imply that this should not be a material exposure in the commodity basket.
  This is especially the case given that the two largest exposures in commodity indices (Copper and Aluminium) are material exposures; and, 

• While the oil and gas exposure is material at 3 per cent of sales, it is not particularly large. This is especially given that it will be an input to production for most companies, albeit probably not material to financials. Australia is also a net importer of oil. For these reasons, it is logical to maintain a material energy exposure within a commodities portfolio.
  There are also a range of other indirect commodity price exposures to which Australian investors are exposed:
• Energy and materials exposure in global equities;
• Commodity exposure in the inflation indexation component of inflation indexed bonds (though if the objective is inflation plus then this overlap is a good thing);
• Energy and materials exposure (and arguably highly correlated growth) in emerging market equities; and,
• AUD/Commodity price correlation (though to the extent investors hold foreign exchange exposure this is a proxy for a “short” exposure to commodity prices). 

Other academic studies have provided evidence that resource stocks are more highly correlated to equities than they are to commodity futures. 

This makes intuitive sense as listed equities movements should expected to be in line with the broader equity market, particularly in the short term. 

Equities also face financial and operational risks that are not directly related to commodity prices. Finally, commodity based equities provide a different exposure from commodity futures, the price of equities is (at least in theory) sensitive to expected commodity prices into the future, whereas futures provide more of a “current” price exposure. 

Commodities as an inflation hedge 

Both equities and bonds tend to perform poorly when inflation is rising. There is a substantial body of research indicating that there is evidence of commodities providing a hedge against inflation, particularly unanticipated spikes in inflation. 

The IMF paper referenced also illustrates the positive sensitivity to inflation for a diversified basket of commodity futures to be around three times that of gold – although gold did provide some inflation hedging benefits. 

On the other hand, broad commodity indices are exposed to energy, industrial metals, precious metals, livestock and agricultural commodities.

It is therefore possible to construct a tailored basket of energy, livestock and agriculture that avoids much of this doubling up in exposure. 

For example, investors could consider tailoring their investment exposure to approximately one third energy and two thirds livestock and agricultural commodities.

When combined with broader equity market exposure, this would provide an improvement in the overall diversification of investment portfolios.  

Tailoring the commodity futures basket to better complement the exposures that investors already get from equities has a large impact on the diversification benefit from the exposure, with the correlation generally being negative, and much more reliably so than a simple off the shelf commodity index. 

Conclusion 

As Australia’s population ages, there needs to be an increased focus on risk in investment strategies. One of the key levers used by investors to do this is diversification. 

Australian investors have recognised the limited opportunity set available locally for many years, and so sought offshore diversification.

The next logical extension of this is to go beyond simply accessing a bigger opportunity set, and to think more deeply about how to make the offshore investments complement local exposures. In this article a couple of simple illustrations have been used to show how this can be achieved.

Through tailoring in this way, each component of an overall portfolio can better diversify the whole, and in so doing produce a more robust outcome for the end investor. 

Michael Blayney is Head of Diversified Strategies with Perpetual. This is an abridged version of the paper that won the Editor’s Pick Award 2013 for Best Due Diligence Forum Research Paper at the recent PortfolioConstruction Forum Conference 2013.