Most advisers intuitively understand the benefits of diversification. Known as the “only free lunch in finance”, diversification is an essential tool for managing portfolio risk and smoothing client returns. Unsurprisingly there is a wealth of information available from research houses, asset consultants and other industry commentators on the right asset class mix for each client’s risk level.
However, one area which is not addressed enough in our view is the fact that not all asset class exposures are created equal. While it’s usually clear for example that a large cap international fund with a Global MSCI benchmark may behave differently to an unconstrained global tech stock fund, there are also other, sometimes less obvious things to consider. Here are a couple of examples:
Hedged vs Non-Hedged Currency on International Exposure
While again this seems obvious, many investors are often surprised at the actual extent of the difference in behaviour between hedged vs non-hedged international exposure, particularly during times of market stress. This is because the AUD, which tends to sell-off heavily during global equity market corrections, can act as a significant shock absorber on unhedged portfolios during a crisis. Conversely however, particularly during a commodities boom, a rising AUD can significantly hinder the performance of an unhedged allocation to international equities in a bull market.
For illustrative purposes, the graph below shows the historical difference in performance through the GFC between a portfolio consisting of 50% Aus equities and 50% international equities currency hedged, vs a 50% Aus Equities and 50% international equities currency unhedged*. While the currency hedged portfolio rebounded more strongly, it would have fallen by -13% more during the depth of the crisis.
Alternatives is another asset class where the type of exposure across products can differ significantly. This is not just due to the different strategies available, eg equities long-short vs a global macro futures based strategy, but also due to differences in individual mandates. For example a long-short equities 70/30 strategy can have a completely different risk profile to a market neutral long-short fund, the former often more closely related to a long-only equities fund in terms of beta risk.
A Total Portfolio Approach
Analysing intra-asset class risks is not just about how that asset class exposure compares to a benchmark index. It’s also about how that asset class exposure correlates with the other asset classes in the portfolio through time.
Unfortunately traditional “managed fund” structures don’t make this analysis easy. The unitised structure of managed funds is a clear barrier to transparency. Exacerbating this problem is the fact that many active managers can be very protective when it comes to disclosing much about their underlying holdings. However it is important for those constructing portfolios to demand greater transparency, or else consider seeking passive exposures where risks are more transparent.
At Resonant we believe in a “total portfolio” approach. One which gives strong regard to the underlying risks within each asset allocation mix, not just to the headline asset class mix itself. Further, these underlying risks should be measured and monitored, and compared against the correlating risks from other asset classes. Only then can a portfolio truly achieve its optimal risk return ratio.
Notes: *In the chart, Aus equities are represented by the ASX200 index, while international equities are represented by the MSCI World ex-Australia Index
Resonant Asset Management Pty Ltd, ABN 41 619 513 076, trading as Resonant, AFSL No 511759.
Disclaimer: The Information within this article does not constitute personal financial advice. In preparing this document, Resonant has not taken into account your particular goals and objectives, anticipated resources, current situation or attitudes. You should therefore consider the appropriateness of the material, in light of your own objectives, financial situation or needs, before taking any action. You should also obtain a copy of the PDS of any products referenced before making any decisions. The data, information and research commentary in this document (“Information”) may be derived from information obtained from other parties which cannot be verified by Resonant and therefore is not guaranteed to be complete or accurate, and Resonant accepts no liability for errors or omissions. Resonant does not guarantee the performance of any fund, stock or the return of an investor’s capital. Past performance is not a reliable indicator of future performance.