Tips to manage equity risk
As 2015 draws to a close, we explore some key investment fundamentals that can serve investors well in this challenging environment: equity risk premium and the power of diversification.
Experienced investors can be forgiven for wondering how they are going to continue to make money in financial markets. Cash rates globally are low and are likely to remain low especially in Australia. Despite the expected increase in US cash rates in the next few months, the path to significantly higher rates is likely to be a slow one. Reflecting this, bond yields are still only marginally above their all-time lows and yields in other asset classes are not offering much in the way of growth. In this article, we explore some key investment fundamentals that can serve investors well in this challenging environment: equity risk premium and the power of diversification.
Equity risk premium
Overwhelmingly, the data tells us that there is a premium over cash and bonds from investing in equities. As a general rule, high-risk investments are compensated with a higher premium. This is referred to as the equity risk premium (ERP) and it reflects the excess return that compensates investors for taking on the relatively higher risk of equity investing.
While the concept of an equity risk premium is valid, it cannot be relied on during times of major secular dislocations (such as the inflation of the 1970s and indebtedness of companies and consumers leading into the global financial crisis).
Our assessment and outlook
While over very long periods the excess return of shares over bonds has varied, since 1900 the realised equity risk premium has averaged over 4.5% for the US sharemarket and close to 6.0% for the Australian sharemarket. We recognise that the starting point valuation exaggerates this return, so our assessment is that the appropriate ERP going forward is somewhere around 3.5% for developed market equities and between 4 to 4.5% for Asian and emerging market shares, reflecting greater volatility.
Although the long term ERP remains positive, our starting point is not as attractive as it was a few years ago. As equity markets have continued to rally, the valuation buffer has reduced. It will still pay to hold shares over the long term, but with increased risks and expectations of higher volatility, diversification becomes paramount. If we look at equity valuations today, the US market looks to be close to fair value, while other markets such as Europe, Japan and Asia continue to offer relatively attractive value.
Furthermore, the relative performance between Australian and offshore equity markets has also changed. Up until the global financial crisis, Australian investors had for many years benefitted from the resilience and outperformance of Australian shares. However, Australian shares have underperformed global markets over the past five years and this is likely to continue with growth being subpar, the banks remaining under pressure to improve balance sheet strength and continuing headwinds from the commodity sector.
The power of diversification
Diversification – often called the ’only free lunch in town’ – is all about trying to diversify away from equity risk which is typically the biggest risk in most portfolios. It seeks to identify and invest in assets and strategies that are uncorrelated to equity risk, specifically risks related to economic growth and its impact on company earnings.
Below are some assets that can play an important role in portfolio diversification:
- Bonds: The most obvious diversifier is that from investing in government bonds. In the event that economic growth falls, typically you see cash rates lowered which reduces bond yields and increases capital value. The longer the maturity or duration of the bond, the more price sensitive it is to changes in the bond yield. Interestingly, bonds can outperform equities in the event of a significant correction thereby providing some offset to losses.
- Currency can be another important diversifier given the Australian dollar’s propensity to underperform in falling equity markets.
- Property and infrastructure both listed and unlisted offer some correlation to economic growth but are also linked to supply and demand factors, inflation and cash rates. As such, they can perform differently to equities.
- Private equity is affected by economic cycles but is also influenced by the underlying manager’s capability in turning around and extracting value from businesses. The strategies adopted by private equities firms often have a very low correlation to the macro economy.
Diversification is not only about allocating to different asset classes. Other considerations include:
Within equities, it is increasingly important to diversify equity risk through value add or active management. This is particularly important in a lower growth environment where individual company fundamentals will be critical in terms of defining success. In addition, alpha (excess return above an index) can be an important part of an overall portfolio’s return in a low return environment.
Taking active management one step further
Consider hedge fund and absolute return strategies where the underlying drivers of success relate to manager skill. This could be in selecting which stocks to go long and which to short, exploiting mispricing in the market and capitalising on risk premiums (such as capturing the premium that acquiring companies tend to pay for target companies or the optionality within convertible bonds).
Managing the style factors in your portfolio
You can under or overweight factors that you believe are likely to outperform in different environments. For example, low volatility stocks tend to perform better in downturns than growth stocks and over long time periods value stocks tend to outperform.
Investing in a portfolio which takes dynamic asset allocation decisions
Adopting a dynamic approach to asset allocation could mean moving the amount held in various asset classes within a narrow range, taking tilts to underlying countries, currencies, fixed interest markets, asset classes or more actively changing the allocation between asset classes to significantly change the risk profile of your portfolio and therefore the factors that are likely to drive performance.
With cash rates and bond yields likely to remain low, even with single digit equity market returns, investors will continue to be compensated for risk and equities should remain an asset class of choice. But the portfolio construction decision should not stop there. The days of easy gains are behind us and so having a properly constructed portfolio that actively seeks to allocate to diversifying asset classes and strategies will become increasingly important in continuing to generate portfolio returns.
About the author
Debbie Alliston is the Head of Portfolio Management within the Multi-Asset Group. Debbie is responsible for overseeing the Group’s multi-asset investment capability which specialises in the management of diversified portfolios. This includes portfolio construction and asset allocation, monitoring and risk management.