“Risk is our business!” Captain James T. Kirk exclaims across his briefing room in the classic Star Trek episode, Return to Tomorrow. “That’s what this starship is all about. That’s why we’re aboard her.”
What, you may ask, do the voyages of Kirk, Mr Spock, Dr McCoy and the Enterprise have to do with portfolio construction?
A great deal, as it turns out, given that when building a portfolio, investors may feel they are boldly going where no one has gone before.
But while many have in truth made this oft daunting journey, if an investor is thinking about building a portfolio and is fearful of taking the first step given all the risks to be confronted along the way, the best place to start is where they would think – the beginning.
For those investors in accumulation phase, the first thing they should bear in mind is the timeframe that is expected to pass between now and their retirement, says Stuart Fechner, director, research relationships, at Bennelong Funds Management.
“This is important before moving to the asset allocation decision and determining the mix between income and growth assets. The asset allocation mix is the key to balancing both the return and risk objective for any investor,” Fechner says.
Cesar Farfan, head of retail sales at Perennial, says for those in accumulation phase, a good starting point is simply thinking about goals and objectives – what the investor is trying to achieve, whether it be income and/or growth, or wanting to retire and with X amount of dollars.
Once they know that, then they can start with asset allocation, Farfan says. And when they get their asset allocation mix right then they can delve into “what’s under the bonnet” in terms of equities, fixed interest or property, and then pick their funds and securities.
This contradicts the starting point for a lot of investors, Farfan says, who erroneously begin their portfolio construction journey in reverse by asking, “What do I buy, Woolies or Telstra?”
Lacking aggression: a real risk
Bell Direct equities analyst Julia Lee argues that the accumulation phase is about boosting assets for retirement, so it therefore makes sense to concentrate on growth assets and strategies which should help to boost capital with higher returns.
Stephen Bruce, director of portfolio management at Perennial, agrees with Lee, taking her point a step further by saying that early in the accumulation phase, the “real” risk investors face when building their portfolios is that they’re not investing aggressively enough should they want to achieve their long-term objectives.
“So, people worry about risk – downside risk or whatever – which isn’t really relevant when you’re 20 years out from drawdown,” Bruce says. “Self-managed super funds are sitting there with piles of cash, but you don’t want to be like that when you’re in accumulation phase.”
Farfan reaffirms Bruce’s point about risk, saying that if an investor is 35 or 45 they should simply be long on equities, reinvesting their dividends and getting the benefits of compounding. Then, they should be dialling back their risk profile as they approach drawdown phase.
Lee believes that when determining how much risk to take on during the accumulation phase, a general rule of thumb is that an investor’s age represents the percentage of lower-risk investments that they should hold, with the balance being growth assets.
“This would change according to an individual’s financial situation, needs and risk tolerance but serves to demonstrate the relationship that most people have with risk over time,” she says.
Perennial’s Bruce is quick to point out the importance of ensuring that assets within the accumulation phase are robust in nature, that is, that they can survive the “downs” and recover.
Therefore, at the asset level, he says any security or structure that is carrying too much debt, which can result in permanent loss of capital, is best avoided, while having a well-diversified exposure to a stable of quality equities is desirable.
Bennelong’s Fechner points out that within the accumulation phase, an investor will typically have a longer-term investment timeframe. And if this is the case, he agrees that there should be a bias in exposure to growth asset classes.
“How much exactly will also depend upon the level of the related risk profile,” he says.
Fechner also says it is important to have diversification across different growth asset classes – not just different in terms of the number, but also in terms of them having different correlations.
“Overall, this can provide for a more robust portfolio across an entire investment cycle,” he says.
“The asset classes may include both Australian and international shares, Australian and global listed property (and consideration of direct property), infrastructure (listed and/or direct) and absolute return/alternative funds.”
Everything in moderation
When discussing about what asset classes to avoid in the accumulation phase, it is Fechner’s belief that everything should be “in moderation”.
“As long as respective asset classes and their risk/return characteristics are understood and used appropriately, it’s hard to say that any should be avoided – especially if taking a long-term investment horizon into account,” he says.
“It is important, however, not to be overly reliant or allocated to any single asset class or investment type.”
Bell Direct’s Lee believes that because the accumulation period is about increasing capital rather than focusing only on conserving capital, cash should be avoided: “A high cash balance will only deteriorate returns over time.”
Perennial’s Bruce reiterates this point, saying it makes sense to avoid cash as well as fixed income in the accumulation period.
“So, if you’re in accumulation now, why would you buy an asset that’s going to give you capital loss as interest rates rise and a three per cent yield or a two per cent yield?”
Managing longevity while drawing down
So, when the accumulation phase of life is done and dusted, what does an ideal portfolio look like in the drawdown phase? Fechner says it needs to appropriately match an investor’s risk profile and have sufficient liquidity.
“You can’t draw down on illiquid assets, especially not in a timely manner. Some exposure to direct assets can make sense, but investors must be wary of an overallocation to non-liquid assets,” he says.
While investments can be sold down to facilitate drawdown payments, it can aid the efficiency of payments in this phase if a good portion of assets within the portfolio are income-producing, Fechner says.
“The portfolio would need to have sufficient downside protection should equity markets suffer a severe fall, but at the same time have appropriate allocation to growth assets so the investment lasts the duration of a person’s retirement and hence overcomes longevity risk,” he says.
Lee also says that growth assets are still important in the drawdown stage given people now tend to live longer than expected, however, portfolios are often weighted towards lower-risk assets.
Perennial’s Bruce agrees with Lee that it’s important to have an eye towards capital growth over this period and generating a decent amount of income, given life expectancies and therefore drawdown periods are now longer.
“So, whereas in a higher interest rate environment perhaps you could have relatively more in fixed income and cash, people will increasingly need to look for other things like high-yielding equities as a bigger piece of that portfolio in pension phase or drawdown phase,” he says.
“The thing about equities is you get a higher level of income and you are going to get capital growth over time as well, and offset inflation.”
Fechner also believes that the clarity of “funds for a purpose” is a good mantra for investors to adhere to.
“For example, this could be having some assets for the purposes of growth, others for the purposes of income, and some assets to play the role of stability or protection when equity markets are negative,” he says.
On the subject of which asset classes are bet avoided during drawdown, Fechner again is a firm believer in moderation.
“It’s important to understand the risk/return characteristics of each asset class (and the funds within each) and how they can align to play a role in meeting the investor’s goals and objectives,” he says.
“Especially in selecting investment funds, the clarity of ‘funds for a purpose’ is a good mantra to adhere to.
“As noted previously, the level of illiquid assets held within the overall portfolio needs to be closely monitored.”
Bell Direct’s Lee says any investments that may require additional capital such as derivative products should generally be avoided.
“High volatility is generally undesirable during drawdown, while in our younger years we have the capacity to bounce back from substantial external shocks, such as being invested in the share market or property during the global financial crisis,” she says.
“As we age capital preservation becomes equally important if not more important than capital returns, especially if we need to withdraw funds in a short time frame.”
Everyone makes mistakes
When building a portfolio, Fechner argues that the use of passively managed index funds has been overdone and therefore actively managed funds have, to some extent, been under-utilised.
“An appropriate fee level is important, but I feel many investors have used this as the primary driver of their decision to invest – more so than the merits of the fund’s investment strategy and approach – which can present some risks,” he says.
Additionally, as the baby boomer generation moves further into retirement, there will be a greater need for strategies that provide a sound level of growth but have some flexibility or strategy for downside protection, Fechner says.
“Such strategies may include long/short variable beta funds, or funds that have a deliberate tail-risk/downside protection strategy in place,” he says.
“This is about identifying funds that deliver a strategy for specific needs and outcomes – as opposed to an over-reliance on index funds and hoping that the natural outcome of the market will work in your favour.”
Lee laments that investors tend to have a strong domestic bias when constructing their portfolios, which means that many of them are missing out on opportunities in the global market.
“Whether it is through exchange-traded funds, managed investments or direct investments, investors should be aware of international opportunities, which are now easier to access,” she says.
Bruce thinks another common mistake that investors make when building a portfolio is selling at the bottom and being scared out of the market.
“I think you know if you’ve got quality assets in your portfolio, you should ride it through. Something we hear when we talk to individual investors, time and time again they talk about how they decided or their adviser in hindsight might have given them advice they regret, of selling at the bottom,” he says.
Fechner believes a common and avoidable error that investors make in portfolio construction is not being truly and properly diversified.
“Just because you hold either 20 direct shares or 10 different managed funds doesn’t mean you have a well-diversified portfolio. It’s not about the number of holdings, but about how they correlate and interact together under different market conditions,” he says.
Lee says a common mistake that investors make is not remembering that if a portfolio is growing properly, its asset allocation should change.
“Those investments with the greatest return should form a larger part of the portfolio. As the portfolio changes, it may no longer be tracking to reflect an individual’s return and risk expectations,” she says.
“One investment may dominate the portfolio. It’s important to understand that a portfolio isn’t set in stone and may need a rebalance to maintain the investor’s goals and needs.”
Finally, beware the chameleon time bomb
Perennial’s Bruce says another trap people fall into is that assets often change their character – the real estate investment trust being the perfect example, back in their pre-GFC days, where they morphed from being safe and reliable, “sleep-at-night,” income-producing investments to highly geared “time bombs”.
“And retail investors were just full to the boots with them as the market rolled over. So, not only did the sector get decimated on the way down, but because their balance sheets were bad, recapitalisation basically gives you this dilution you never recover from at the bottom,” he says.
“So, a lot of retail investors are just not aware of the changing nature of some of the things they’re getting into.”
Bruce says this danger is also present within certain structured products that carry so-called capital guarantees. So, they are also best avoided.
“Simple usually works better … it sort of creeps up on you how these things change. REITs didn’t go from being safe and reliable one day to risky the next. It happened over a period of time.”
This article was first published on Money Management.