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Avoid equity volatility by increasing your allocation to bonds

by Dr.Stephen Nash | Jun 12, 2013

Introduction

In some ways, the following question typifies the problem facing investors,

Consider the following situation. If you had a loaded dice, and the odds were two thirds you “win”, and one third you “lose”, and the bet was $100,000. Now, if you lose, you could lose between 15 and 30% of $100,000, and if you win you make between 15% and 30%. The question remains, would you take the bet, or would you like to reduce the odds that you lose?

Most people would not take the bet, as the threat of loss is too high, even though the odds remain in the favour of the risk-taker. In many ways, an equity biased portfolio provides similar odds of “winning”, as described above, and while many would not take the bet as specified above, they effectively do the same thing in their investment portfolios every day of the week.

There is another way; better portfolio design.

Specifically, better portfolio design, as suggested herein, effectively pushes the odds even further in your favour. In particular, in setting your fund asset allocation, the following three steps can assist investors more effectively match assets, or investments, with underlying future payments, or liabilities:

  • set a conservative target return for the future expenses, or liabilities, faced by investors
  • evaluate the historical risk and return of two alternative asset allocations
  • consider the prospects for future volatility

Finally, we draw these various arguments together, as they specifically relate to the needs of investors.

Estimated liability target hurdle return

A well accepted format for investing is what is known as liability driven investing, where assets are selected with reference to the underlying future expenses of the pension plan in question. This approach starts from the premise that investors would not have any assets to invest if they did not have future expenses to meet, and these expenses can be thought of as the liabilities of the pension plan in question. This format of investing is well accepted in the UK, Europe, and the US, as it places investment discipline on all participants and asset allocators, so that asset selection is always made with reference to the future pension fund liabilities.

Investors need to set a hurdle rate for their investments, relative to CPI, since inflation erodes the value of savings and needs to be beaten in order to preserve the value of savings over time. This hurdle rate needs to be conservative, but needs to also ensure adequate return is garnered, so that future liabilities can be met. This is why large sovereign wealth funds, like the Future Fund, specify investment objectives relative to the CPI. Specifically, the Future Fund has a return target of between 4.50% and 5.50% over inflation. [1]

If we make the hurdle a little lower, say around CPI plus 3%, then this becomes a realistic and very conservative target for the pension plan in question, over the medium term. As Figure 1 indicates, this hurdle is quite volatile, with an annual volatility of around 1.50%, and average return of around 5.50%. This means that the hurdle rate can be expected to be within the range of 5.50% less 1.50%, or about 4% (the grey line in Figure 1), and 5.50% plus 1.50%, or about 7% (the light blue line in Figure 1), most of the time.

Figure 1

Evaluate historical risk and return

Details from Figure 1 are then placed against the annual return results for the following two portfolios, using daily data from 1990 to the present:

  • 75% equities and 25% fixed income, or what the market sees as the typical “balanced” portfolio
  • 25% equities and 75% fixed income

As Figure 2 shows, these portfolio asset allocations provide very different ways to meet the required hurdle rate, and in summary, both portfolios beat the hurdle rate, and the average returns are as follows:

  • 75% equities and 25% fixed income, returns an average of 9.94%, which beats the hurdle rate by 6.94%
  • 25% equities and 75% fixed income, returns an average of 9.19%, which beats the hurdle rate by 6.19%

In other words, both portfolios comprehensively beat the hurdle rate of 3% above inflation, yet the volatility of each asset allocation is dramatically different. Specifically, the volatility of these allocations is as follows:

  • 75% equities and 25% fixed income, has an annual volatility of 12.03%, which means that return will vary between 9.94% less 12.03%, or -2.09%, and 9.94% plus 12.03%, or 21.97%, most of the time
  • 25% equities and 75% fixed income, has a volatility of 5.57%, which means that return will vary between 9.19% less 5.57%, or 3.62%, and 9.19% plus 5.76%, or 14.76%, most of the time

Figure 2 shows the volatility of the 75% equity portfolio (25% fixed income), or the grey line, while the lower equity weight, the light blue line, is much less volatile. In fact the 25% equity portfolio (75% fixed income) has 92% of the return provided by the high equity allocation, with roughly half the risk.

Figure 2

Such an allocation seems to be appropriate for conditions of ongoing equity volatility, as we consider below.

Equity volatility – is it a thing of the past?

Equity investors, who think that volatility is a thing of the past, may need to think again, as the local equity market has drifted significantly from the recent high already. Several reasons for this decline are being suggested:

  • withdrawal of Fed quantitative easing
  • cuts in fiscal spending reducing US economic growth
  • the Australian economy struggling to transition from mining to non-mining led growth
  • concerns that delinquency rates on bank loans may rise with unemployment
  • conservative consumers not responding to accommodative policy from the RBA
  • business sentiment weakened by the prolonged election campaign

All these reasons are contributing factors, yet they all tend to suggest that economic growth is proceeding at a slower rate than had been expected, when equity market volatility was lower, earlier this year. Since then we have seen equity prices fall and volatility increase, as Figure 3 indicates.

Figure 3

Conclusion

At the outset, we likened the typical asset allocation decision to taking a bet, for a large amount of money. While this might seem an extreme characterisation, the fact remains that the typical asset allocation in Australian pension plans is more aggressive than it needs to be. We argue that an adequate target return for your liabilities is CPI plus 3%, and while investors can easily beat that with credit ILBs, the idea of a smaller equity allocation, and a higher fixed income allocation represents another way to beat this hurdle return.

In a situation where most central banks have already stimulated to the full extent possible, there is little else that they can do. If growth fails to meet current high expectations, then equity volatility will not be a thing of the past, but a thing that dominates investment conditions, going forward. In this context, getting much the same return as the typical “balanced” portfolio of 75% equities and 25% fixed income, with half the risk, seems to be a good idea, and this article has outlined how this outcome might be achieved. Both allocations beat the liability return hurdle of 3%, yet the higher bond weighting does it more effectively, with much lower risk.

Essentially, better portfolio design, not necessarily more risk, is the intelligent way to approach the investment problem.

[1] Future Fund “Briefing”, 5 February 2013.