Dr Stephen Nash looks at asset allocation and why some balanced funds are not so balanced.
When a prominent and respected figure reiterates themes and arguments that have been illustrated, then the credibility of these arguments is elevated somewhat.
Recently, comments by Dr Ken Henry – Secretary to the Treasury of the Commonwealth of Australia (April 2001 – March 2011), ex-officio member of the Reserve Bank of Australia board, author of the Henry Tax Review, special advisor to the Prime Minister of Australia (June 2011 – present), and currently leading a Commonwealth of Australia White Paper on the topic “Australia in the Asian Century” – have supported two main themes of FIIG research, which are as follows:
- A 70 per cent allocation to equities does not constitute a balanced fund;
- Age necessitates conservatism in asset allocation.
Accordingly, this article will assess the Henry comments as they relate to these two themes before revising these arguments.
While many things can be said about Dr Henry’s comments, the main idea is that investment focus should be firmly on risk, and that return has been over-emphasised in asset allocation to date.
Ken Henry comments
In a recent article in the Sydney Morning Herald, Henry made several statements that support several FIIG Securities themes.
1. “Balanced” is not 70 per cent growth
Here, Dr Henry indicated that the default allocation to “growth” assets of around 70 per cent is much higher than global peers, where in contrast, most global peers hold over 50 per cent of the portfolio in conservative assets like bonds.
While fund managers defend the current allocations on the basis that “average” returns are better in equities, Henry argues that “average” returns are inappropriate for many investors – especially older investors, as discussed below.
He points out that Australian investments are generally biased away from bonds, when compared to other comparable OECD countries (Refer to Figure 1).
Dr Henry also highlighted that Australian pension funds are overweight equities, relative to global OECD peer countries, (Refer to Figure 2), where Australia has one of the highest weightings to equities.
Such a heavy weighting to equities is a dangerous situation if you consider the size of the Australian pension system relative to gross domestic product (GDP).
Here, Australia ranks very highly, as the pension system is approaching 100 per cent of GDP, and typically, as the size of the pension system increases relative to GDP, the system becomes more conservative as the risks build for economies with large pension systems.
Australia, however, seems oblivious to such risks.
2. Age necessitates investment conservatism
According to investment managers, investors should shoulder the risk of equity investment in order to reap the rewards of investing in equities.
Yet investors are not a homogeneous mass. Specifically, some investors have very different capabilities when it comes to shouldering risk.
Some investors accept risk much more easily than others, and some are also much more patient with investments when compared to other investors.
However, age is an important criteria for accessing the capability of an investor to shoulder investment risk. Age restricts the time available for an investor to recoup investment losses. As Dr Henry indicates,
Depending upon when they enter the system and when they retire, some fund members will benefit enormously from a portfolio weighted heavily towards equities, while others will lose big time … and nobody knows, in advance, who will win and who will lose.
For example, someone who was 59 years of age around 2007 (and was preparing to retire near the age of 60) would have suffered a loss of almost 50 per cent of their superannuation if they were in a fund that had a high allocation to equities, just prior to retirement.
Let’s analyse the outcomes of a market that does not recover (or revert to the mean) after a decline in equities, using the following assumptions:
- A fall in equity prices is not mean reverting – implying a somewhat permanent fall in growth expectations;
- Recapitalisation can proceed at a constant rate of 5 per cent for the life of the recapitalisation period;
- Investor life is limited to 100 years;
- Inflation is ignored;
- Equity returns are analysed, without the risk-dampening impact of fixed income.
Some may argue that the first assumption is too severe, since it implies that equity prices fall and do not rise for the entire recapitalisation period.
However, you could also argue that the reinvestment assumption is not realistic, since if equity prices did fall and stay low, then interest rates would fall, so the reinvestment rate would be lower.
Limiting investor life to 100 is possibly optimistic, yet it accounts for increases in longevity over the next twenty years.
Ignoring inflation is something an investor does at his/her peril, yet incorporating inflation would complicate the analysis and obscure the basic message of a fairly simple analysis.
Table 1 shows the modelling of a series of non-mean reverting falls in equity prices and the time taken to recoup those capital losses.
These falls are then recapitalised at 5 per cent, and the time taken to recapitalise is computed in columns E (20 per cent equity decline).
In the case of a 20 per cent equity decline, it will take around five years to bring the capital of the investor back to where it was before the equity decline, and this increases with the severity of the decline out to 30 years for a 60 per cent decline in equity prices.
Notice how this period of recapitalisation, while fixed, makes up a larger and larger percentage of the investment horizon.
Conclusion
Risk needs to be considered in your portfolio, not just return. Having a solid allocation to bonds can moderate overall portfolio risk dramatically.
Bond prices typically move in the opposite way to equity prices, so that as equities decline, bonds rise from the ashes and support overall portfolio returns – just at the time such support is most needed.
Dr Ken Henry has recently supported FIIG arguments with regard to two important investment themes. First, the typical “balanced” portfolio needs more bonds and less equities.
Second, older investors need to recognise the implication of their age on their asset allocation.
Age forces more conservatism in portfolios, so less equities and more bonds are needed. Younger investors can be much more aggressive as the investment horizon for such investors is much longer than for older investors.
All prices and yields are a guide only, and subject to market availability. FIIG does not make a market in these securities.
Dr Stephen Nash is the director of strategy and market development at FIIG Securities.
