By concentrating investment on a narrow range of Australian assets, investors might be exposing themselves to more, rather than less risk, according to MLC’s Michael Karagianis.
Five years after the global financial crisis (GFC), many investors in Australia continue to struggle with the longer-term implications produced by a fundamentally new investment environment.
This more challenging environment is characterised by markedly lower investment returns and higher risk. The period since the peak of the Australian equity market has seen returns much lower than the 20-25 per cent per annum returns averaged in the lead-up to market's peak.
Alongside this, market volatility has remained elevated since the GFC, with frequent downdrafts producing a very uncertain ride for investors.
The initial perception by many investors was that this new environment was a temporary aberration; it was only a matter of time before the All Ordinaries index would revisit its previous highs.
Five years down the track, however, and the share market remains significantly below those highs.
In reality, the post-GFC environment should be viewed as a new investment paradigm requiring a careful assessment and understanding of risk and new portfolio construction ideas.
A tough time for retirees
By perhaps unfortunate coincidence, just as the business of investing has gotten a whole lot tougher, the proportion of the population becoming dependent on retirement savings is rising.
For those in or soon to enter retirement, this new investment paradigm couldn't have come at a worse time.
Most retirees have little or no recourse to other income to supplement their retirement lifestyles at the same time as their savings are being buffeted by unpredictable returns.
The response of many Australian investors to the post-GFC challenges has been to seek more cautious strategies.
However, many investors are investing in strategies that may be riskier than they fully understand.
I commonly see investors with Australian-biased portfolios comprising a mix of Australian shares, Australian property and cash deposited in Australian banks (term deposits).
As term deposit rates have recently dropped below 5 per cent, we have seen rising interest in Australian corporate debt issues, particularly hybrids, to supplement returns.
This mix of assets seems to have a fairly broad diversification across shares, property, cash and bonds.
Understandably, by maintaining a wholly or largely Australian bias in their portfolio, investors are responding to global uncertainty by a focus on local investments, which are seemingly far removed from the troubles plaguing the global economy.
Ostensibly a portfolio strategy such as this may appear to be insulated from many of these global concerns.
The reality may be very different. By concentrating investment across a narrow range of Australian-oriented assets, investors may in fact be significantly increasing the investment risks they are exposed to.
The risk of a more concentrated Australian share market
One of these risks is a function of the changing structure of the Australian share market.
A decade of strong outperformance from the materials sector as a result of the mining boom has produced a markedly different structure in the Australian share market.
As has been seen during the past year, the share price index is increasingly captive to the ebbs and flows of the Chinese economy.
Should the Chinese economy materially disappoint in the future, it would have painful consequences for the materials sector and the share market index as a whole.
For many retirees, while investing in Australian shares may still be quite relevant, the structure of the Australian share market as a whole may have become increasingly misaligned with their needs.
Retirees in particular need great predictability of income flows to maintain a lifestyle and to be able to insulate against the effects of future inflation.
This suggests a greater focus on higher yielding shares with predictable earnings and relatively lower volatility.
But these are not generally the characteristic of the materials sector.
Retirees need to consider more carefully the characteristics of the share portfolio they are investing in to ensure it meets their needs and avoids unsuitable risks.
However, given the concentrated nature of the Australian share market around the materials and financials sectors, there is a need for greater diversification than is available through just the local market.
The relatively smaller exposure to the materials and financials sectors in many offshore markets can markedly improve the diversification of Australian-only portfolios.
Be aware of common factor risks
A lack of diversity in the Australian share market is not the only concern for investors in Australian-biased portfolios.
Given the heightened dependence of the Australian economy overall on China, there is a common factor risk associated with many Australian assets.
A common factor risk describes the potential exposure of a portfolio to a common theme or potential event which, if it were to occur, would produce a similar impact across a range of seemingly well diversified investments.
An Australian-biased portfolio of shares, property, cash and hybrids, whilst apparently well diversified, has a common thread running through it making it exposed to the potentially detrimental effects of a prolonged Chinese slump.
The most obvious impact of a prolonged Chinese slowdown, were it to occur, would likely be a sharp slump in the Australian mining sector.
However, the negative income shock from a sustained Chinese downturn would have implications for the broader economy, likely resulting in a tougher profit environment for companies outside of the mining sector as well.
This would have ramifications for the share market more broadly but also potentially negatively affect the performance of hybrid bonds issued by the same Australian companies.
An increase in Australian unemployment in such a scenario could also produce a negative shock for the housing market, potentially resulting in a correction to housing prices and rental incomes.
This would have a materially detrimental impact on Australian investors as whole given the predominance of residential property in household wealth.
Even cash invested in term deposits would not be immune from the impact. Interest rates in Australia would be headed materially lower.
Already around 4.5 per cent, bank term deposit rates in such an environment could conceivably gravitate towards zero, similar to what we have seen in the US and Europe since the GFC and Japan since the early 1990s.
This would be insufficient to generate sufficient income for lifestyle purposes let alone compensate for any inflation.
The scenario of a prolonged Chinese slump may be considered to be extreme but it is by no means impossible.
It does demonstrate the latent dangers associated with under-diversification within many commonly observed Australian-biased portfolios, and with common factor risks which may run through an investment portfolio but are poorly understood.
Understanding and diversifying portfolio risk
The best guard against such an uncertain global environment as exists today is not, as conventional wisdom might suggest, to consolidate all portfolio investments inside Australia’s borders.
Rather the best defence is to fully understand the nature of the risks embedded in a portfolio and to increase allocations to a wider range of more genuinely diversified investments that, combined, provide the best chance of successfully meeting one’s investment objectives across a range of potential investment scenarios.
Michael Karagianis is a senior investment strategist at MLC Investment Management.
