All assets have inherent risk which varies from security to security and asset class to asset class. Equites for example, have earnings risk, balance sheet risk and valuation risk, and property has vacancy risk, rent default risk and price risk. Bonds are not exempt from risk either and while they are labelled ’defensive’, there is the risk that the bond issuer may default, or that interest rates rise, causing the price of the bond to fall.
Over the long run, these risks can be managed effectively by diversifying asset classes and by using active management. Consequently, a fundamental decision for every investor is how much to allocate to shares, bonds and cash to achieve their investment objectives. This decision lays the foundation for not only how a portfolio will cope with financial market oscillations, but also how it will produce desired investment outcomes such as safety, income and capital growth.
The key to balancing these three objectives is estimating risk and determining how to diversify it.
The traditional case for bonds
The traditional approach diversified risk by investing in bonds to offset the volatility of equities. Falling sharemarkets are typically associated with a weak economy, declining inflation and heightened risk aversion. Bonds typically perform well under this scenario, as bond holders receive a fixed payment stream irrespective of economic conditions making them a reliable part of the portfolio. Therefore, a combination of growth assets (i.e. shares) and defensive assets (bonds) has the potential to deliver more consistent returns.
This portfolio approach is not a recent phenomenon with bonds having being a steadfast diversifier of equity risk since 1900. Indeed, the total returns of the Australian sharemarket and Australian bond market have both been negative in only five of the past 116 years (1951, 1952, 1973, 1981 and 1994).
There were years of negative 10-year government bond returns as yields rose (such as 1912, 1920, 1980, 2009 and 2013) but these were associated with positive equity markets, and negative years in shares (including 1901, 1915, 1929, 1930, 1941, 1974, 2008 and 2011) which were offset by positive bond returns.
However, the fixed payment stream of bonds which has been a source of reliability is now the asset class’ weakness. With record low bond yields, investors are receiving lower income than ever before, and face the risk of interest rates rising leading to capital losses. A 1% rise in interest rates has the potential to erase 3 years of income at current yields.
This raises the question of how investors in passive conservative funds can meet their return objective by using a fixed asset allocation framework.
Can passive conservative funds live up to their name?
In terms of constructing a framework to balance the objectives of income, capital stability and capital growth, a broadly adopted approach has been to anchor portfolio decisions to long-term risk and return assumptions which also assume stable correlations. However, the risk, return and correlation used assume that financial assets are close to “fair value”. These assumptions can be highly inaccurate when financial markets are expensive and the investment time horizon is short. Invariably, portfolios built using the wrong assumptions end up with incorrect asset allocations to meet their objectives.
Current bonds yields are much lower than the assumed yields used to model return expectations of fixed asset allocation portfolios. In Australia, the current 10 year government bond yield is 2.7% and the Australian cash rate is 1.5%. With around 70% of a traditional conservative fund invested in bonds and cash, it means that the remaining assets need to return a total of 12% per annum to generate a portfolio return of 5%. This is a Herculean task given the low growth, low return and high valuation world that we all live in.
An alternative is that bond yields rise. If bond yields could lift to 4.0%, the required return from the remainder of the portfolio could be a more reasonable 7.5% per annum. While that world would produce more consistent returns, the path to get there is a potentially painful one for bond holders as Australian bonds would incur losses of around -15%, and other international bonds could decline anywhere from -20% to -40%.
Passive conservative investors are in a bind as around 70% of their holdings (bonds and cash) are no longer performing the role they were meant to play.
A simple conclusion
The conclusion here is simple, namely, with low bond yields the static asset allocation approach is very unlikely to deliver expected returns for investors today. That is to say, bond yields could remain where they are, which means their return is limited to the yield, or bond yields could continue to rise, with capital losses outweighing income.
This changes the role of bonds in a conservative fund from being a diversifier of risk, to a driver of it.
A common sense approach needs to be adopted.
How does Perpetual address this challenge? Through active management
At Perpetual, active management is at the core of what we do. We will not invest in assets that are unlikely to deliver on our clients’ investment objectives. Perpetual’s Multi Asset Team recognises and manages valuation and cycle risks by making investment decisions in a dynamic way. Perpetual has been actively managing asset allocation for 20 years.
In the Perpetual Conservative Growth Fund (“the Fund”) the team actively positions the Fund to continue to deliver expected portfolio attributes from this style of portfolio through active decisions at both the asset class and security levels. The Multi Asset Team takes a holistic view when it comes to building portfolios, and understands that taking risk on a single position can be either be mitigated or exacerbated by other positions elsewhere in the portfolio.
To protect capital in a market downturn or from rising bond yields, the Fund has three layers of defence embedded in the process. First, the Fund deploys explicit downside protection; second, it is intelligently diversified (in terms of market exposures and skill based returns which are independent on the direction of the equity market); and third, investment decisions are built around a valuation discipline meaning we avoid expensive assets, even if they are labelled defensive.
How is the Fund positioned today?
- Given current valuations, Perpetual Conservative Growth Fund remains conservatively positioned, being slightly underweight growth assets.
- The Fund remains underweight fixed income both directly through long-dated government bonds and indirectly through yield plays like listed property trusts (although the recent price decline here has prompted us to reduce our underweight exposure). This helps to protect the portfolio from an environment of rising interest rates. Our underweight fixed income position has been augmented by increased holdings of US dollars which is likely to appreciate as the US Fed hikes rates and President Trump undertakes a large fiscal stimulus. The US dollar also has attractive attributes in a ‘risk off’ scenario.
- At the same time, we have modestly increased the exposure to the Perpetual Diversified Real Return Fund (DRRF). The DRRF acts as a portfolio stabiliser given its unconstrained asset allocation framework.
- Elsewhere, we have utilised external capabilities such as Charter Hall to gain exposure to unlisted property, which is less volatile and offers better value than the alternative of listed Australian real estate investment trusts.
What this means for investors
With cash rates and bond yields at very low levels, investors need to ensure they hold a balance of exposures in their portfolio, which can improve their ability to meet their investment objective with downside protection. Within the Perpetual Conservative Growth Fund, we aim to preserve the ‘true’ defensive characteristics of the portfolio rather than ignoring the known risks of “picking up pennies in front of a steam roller”.
The Perpetual Conservative Growth Fund has produced the fourth highest return at the fourth lowest level of volatility in its peer group over the last 5 years.
Chart 1 shows the Conservative Fund peers contained in the Zenith and Lonsec Conservative Growth universe.
Our asset allocation approach leverages the expertise of our investment teams across all major asset classes and its value discipline has been proven over many investment cycles to enhance returns and reduce risk. This approach is the cornerstone to Perpetual’s consistent and strong track record of performance in the Perpetual Conservative Growth Fund, and indeed, all of our multi asset funds.
For more information on the Perpetual Conservative Growth Fund, contact Adviser Services on 1800 062 725 or speak to your Perpetual Business Development Manager today.
This information has been prepared by Perpetual Investment Management Limited (PIML) ABN 18 000 866 535, AFSL 234426. It is general information only and is not intended to provide you with financial advice or take into account your objectives, financial situation or needs. You should consider, with a financial adviser, whether the information is suitable for your circumstances. To the extent permitted by law, no liability is accepted for any loss or damage as a result of any reliance on this information. The PDS for the Perpetual Conservative Growth Fund issued by PIML, should be considered before deciding whether to acquire or hold units in the fund. The PDS can be obtained by calling XXXX or visiting our website www.perpetual.com.au.
No company in the Perpetual Group guarantees the performance of any fund or the return of an investor’s capital (Perpetual Group means Perpetual Limited ABN 86 000 431 827 and its subsidiaries).
LESSONS FROM 50 YEARS OF SHARE INVESTMENT
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