How to earn a good return without too much risk
The risk reward trade off is one of the most important dynamics in financial markets.
The more risk you take on, the higher your potential reward. At the same time, the more risk you take on, the higher the potential for loss.
It’s also important to understand this concept works in reverse. The lower the risk, the lower the potential reward and the lower the probability you will suffer a loss.
Getting this balance right is critical for self-managed super fund (SMSF) investors.
Darren Beesley, senior portfolio manager, AMP Capital, notes diversification is key to getting this right.
Diversifying investments across a broad range of asset classes with different return profiles helps manage risk and maintain the performance of the fund across investment cycles.
However, Beesley says many people have misconceptions about what diversification truly is.
“Some people consider holding several different Australian equities in their portfolio diversified. But this is actually a very concentrated portfolio. As all the investments are in one market, the portfolio is exposed to substantial risk. If the economy stalls or the equity market drops, all the assets will suffer,” he explains.
Interestingly, Beesley says many traditional managed investment funds have a high concentration of Australian equities. Although they may not be aware of it, this lack of diversification can expose SMSF investors to high amounts of risk.
“At AMP Capital, when we start talking about diversification, we think about assets that don't behave like equities. Assets with the lowest correlation to the equity market become the best diversifiers,” Beesley says.
Certain asset classes such as commercial property and infrastructure traditionally have a low correlation to equities.
Fixed interest and safe haven currencies like the US dollar or Japanese yen are in the same category. However, bonds and currencies may not produce the desired level of returns given cash rates and bond yields are currently so low.
Investors can access both listed and unlisted options when it comes to commercial property. Real estate investment trusts are the main option in the listed markets. Because they are traded on public stock exchanges they are correlated to the equities market, which is something SMSF investors should take into account.
However, unlisted property trusts tend to be less correlated to the equities market and can offer strong diversification benefits. There are also funds that invest in both listed and unlisted property assets, which helps to spread risk.
Some SMSFs also directly hold investment properties. This has the benefit of greater control of the asset, but results in a high risk concentration in a single asset., There are also liquidity risks as it takes a substantial amount of time to sell a property asset.
Infrastructure also provides SMSF investors with strong diversification benefits. It’s a particularly attractive asset class as underlying revenue is often supported by highly reliable government contracts, which is a strong source of cash flow.
There are also substantial diversification benefits within the asset class, which includes investments such as energy suppliers, telecommunications assets, roads, railways, ports and airports, as well as social infrastructure such as hospitals and schools. It’s also possible to diversify across different geographic regions.
An airport has very different risk reward characteristics compared to an asset such as a power station, and this diversity of returns helps to manage risk when investing.
SMSF investors are usually not able to directly invest in infrastructure due to the large size of the asset. Typically, investors access this asset class through a managed fund.
Listed investment trusts expose investors to share market volatility, whereas unlisted funds do not. There are also funds that invest in both listed and unlisted infrastructure assets, which can help diversify returns for SMSF members.
Not all commercial property and infrastructure investment funds are created equal. It’s important to understand the source of returns for investments in these categories, including future expected cash flows, leverage, and any underlying risks that could compromise revenues.
Outside infrastructure and commercial property, alternative investments also offer SMSF opportunities to diversify their portfolios. This is a class of investments that covers a wide range of assets, including managed futures, private equity and hedge funds.
But while these assets tend to have low correlation to equities, they often have a relatively high risk return profile, especially compared to lower-risk asset classes such as fixed interest. Fees attached to products in this category can also be high, which can also affect investor returns.
With financial markets becoming more and more sophisticated, options to diversify an investment portfolio are increasing.
However, it is important to remain focused on the core principle of risk management, which is diversification. To achieve this add investments to your portfolio with strong expected returns and low correlation to equity markets.
The idea is to explore the universe of opportunities and form a view about the best way to diversify the fund to help reduce risk and protect returns.