Download Matching the risk profile of your funds with the risk characteristics of

Matching the risk profile of your funds with the risk characteristics of assets
In previous papers we looked at the need to match, in broad terms, the risk profile of an
organisation or portfolio with the risk characteristics of different asset classes.
This paper expands on this theme, providing a deeper dive into the differing risk characteristics of
various asset classes. In particular, it has a NFP focus in that it concentrates on perpetual charitable
trusts without access to capital, or other NFPs where the trustees choose to invest in a similar way,
for either all, or a portion of their investable assets.
This paper looks at two different issues:
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
The risk characteristics of different asset classes relevant to NFP investors, broken down by
capital and income components; and,
How time dampens substantially the volatility of Equity assets in a portfolio. This
underscores why time frame is of critical importance when assessing the real risks
associated with any investment strategy adopted by NFP trustees.
1. INCOME & INCOME GROWTH RISK VS CAPITAL VOLATILITY RISK
The main difference between investing for an entity which takes a perpetual, or very long term view
on the maintenance of its capital base, as opposed to almost all other types of investment, is that
because there is only access to income and the capital (corpus) is solely there to provide future
income, the focus when looking at risks in the investment portfolio are predominantly based on the
risk characteristics of the income portion of each asset class.
As the table below demonstrates, that has the effect of turning most of the conventional views of
the risk of particular asset classes on their head.
The table below looks at the risks to the INCOME portion of an asset class only and considers how
they relate to the following risks faced by most NFP portfolios:
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Current income levels, which need to be high enough to meet current commitments;
The ability to grow income in real terms (after the impact of inflation) over time (to enable
the entity to stay relevant in meeting its spending objectives over the long term);
The year to year volatility of the income from the asset in dollar terms (to make sure that
programs can be maintained and future spending commitments met on a year to year basis);
Tax effectiveness, to ensure that, despite being tax exempt, no unnecessary tax is paid and
all tax benefits for a NFP, such as franking credits paid in cash, are harvested;
Real capital growth. Capital growth after taking account of future inflation is necessary to
generate the real growth in income which is the second objective on this list; and

The volatility of the capital. This is not as relevant if the capital cannot be accessed but it still
can still have relevance. For example, if the annual accounts are published and are used in
fundraising efforts volatile capital can detract from fund raising success. In general, however,
our earlier comment on the relationship between timeframe and volatility is of paramount
importance.
How do the various risks shown relate to different asset classes?
Current
Income
Level
Real
Income
Growth
Income
Volatility
Tax
Effectiveness
P
-
P
P
P
P
-
P
P
-
Bonds /
Fixed
Interest
P
P
-
x
x
x
x
Cash
Term deposits only
x
x
x
x
Australian
Shares
International
Shares
Listed
Property
P Positive
Neutral
x
Real
Capital
Growth
Capital
Volatility
x
x
P
P
Negative impact on asset class shown
The table shows that, if you are only looking at the income component of an asset invested by an
NFP, Australian shares are actually a lot less risky than any other asset class:
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They have a high current income (a conservative portfolio can still generate an income of
6%pa at present, including franking credits)
They have good income growth after inflation (more on this later)
The year to year volatility of income is relatively low and, in most cases, predictable, because
of lagging effects;
They are tax effective for NFP investors in that the franking credits are received back in full
from the ATO in cash;
There is real capital growth which provides real growth in income over time; however,
On the capital side, shares exhibit relatively more short term capital volatility but, if capital is
not able to be accessed, or it is not the Trustees intention to access it in the longer term,
that has little to no impact on appropriate asset allocation decisions.
At the other extreme, cash and fixed interest (bonds) are the riskiest asset classes for a perpetual
charitable fund, if only the income side is taken into account:
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In the current environment income is very low from both asset classes with the exception of
Term Deposits (which still have income at about one half the level of a good share portfolio);
History shows that over the long term there is little or no real income growth from holding a
portfolio of bonds or cash given that both are referenced to the inflation rate over time.
Cash rates produce the most volatile and unpredictable income streams of all asset classes
as they are directly related to central bank decisions on monetary policy and take immediate
effect. Changes in income streams from term deposits have a slightly longer lag, but only in
months, and bond portfolios a bit longer than that.
On the capital side, neither asset class give any material real capital growth over the long
term and, from current interest rate levels, bond portfolios can be expected to produce
negative real returns over the foreseeable future, with the possibility of at least a couple of
years of negative nominal returns in the next few years.
The other asset classes come between those extremes but to pick out some points of interest
from the table:
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International shares are shown as having only average income levels and growth
(although the income growth is closer to Australian shares than it is to listed property
trusts) because as a general rule in most overseas share markets there is less emphasis
on paying dividends than in Australia. Accordingly, equity market yields are significantly
lower than here.
International shares are shown as having negative tax effectiveness. That is because, as
well as not receiving franking credits like Australian shares, a withholding tax is imposed
on income repatriated to Australia by foreign countries which is not recoupable (unlike
for taxpayers) so that money is lost to NFP’s.
Listed property should really be seen as a subset of the equities market although, like
infrastructure shares, it is a subset of that asset class with less income growth and
normally less tax effectiveness, real capital growth and capital volatility than other
components of the listed equities market. However, many of these listed property and
infrastructure investments are also highly geared so in times of financial stress (like the
GFC) or rising interest rates, (something we may reasonably expect over the next decade
or so), they may well exhibit capital volatility equal to, or higher than, other listed
securities.
Therefore, looking solely through the lens of the income generated from a NFP portfolio, and if you
either cannot access, or choose not to access the capital, either in perpetuity or for extended
periods, the “least risky” asset class for a portfolio would be Australian shares and the “most risky”
in the current environment, with an expectation of higher inflation and interest rates over the
medium term, would be fixed interest followed by cash.
2. TIME FRAME AND RISK – INSEPARABLE TWINS
For all investments, risk can never be appropriately assessed until the investment time frame is
specified. This is true for all asset classes, but most especially for the listed Equities markets.
Time is a double edged sword for most investments.
Inflation eats away at the value of assets over time, even in periods of very low inflation. In the 15
years since 2001, the average annual inflation rate has “only” been 2.5% pa. However, that is a total
inflation of 46.5% over that time, which means a cash deposit of $1,000,000 15 years ago would only
be worth about $680,000 in today’s dollars. This assumes of course that all of the income has been
spent along the way. Over the same period, the capital part of the Australian share market (All
Ordinaries), again assuming all income had been spent, rose by 84%, almost double the inflation rate
despite that period encompassing the GFC. However, as we are all aware, that was achieved with
considerable short term capital volatility. We re-emphasise – short term volatility.
The following charts are taken from ground breaking work co-ordinated by the London School of
Economics for the Millennium project in the late 1990’s and updated since then (with this version
from 2006). They show the volatility of annual returns over particular timeframes for both Australian
Equities and Australian Bonds.
The first chart above shows the dispersion of annual real returns (after inflation) for the Australian
share market for holding periods between 10 and 106 years in the period since 1900. It shows that
even for 10 year holding periods, returns were widely dispersed averaging from over 15% pa to
around minus 5% per annum. However, as the length of the holding period increased, that
dispersion came down significantly. Importantly the median returns were about 7.5% pa after
inflation for much of those periods.
The second chart below shows the volatility of returns for Australian fixed interest securities over
the same period.
What do these charts tell us?
1. The price of both asset classes can be volatile when measured over the short term, but as
time frames increase the volatility decreases substantially for both of them;
2. Over rolling ten year periods bonds are not much less volatile than equities;
3. Over the very long term shares produce a return substantially higher than the inflation rate
but bonds do not.
Given where we currently are in the inflation / interest rate cycle, it would not be at all surprising if
the next 20 years produced another negative figure like the ones shown in the chart above.
The message from these charts is that, over the very long term, shares substantially outperform
bonds after inflation.
The other main message is that bonds do not have a significantly lower volatility of returns
compared to shares over very long periods.
We have now been in a secular bull market for bonds lasting over 30 years, with only small relatively
short reversals in that long term trend. Investors who have not lived through the volatility (and
negative returns) that occur in rising inflation periods may well have a false sense of security about
the volatility of that asset class, as well as the real returns it can generate over the long term.
Thus for perpetual trusts, or those wishing to manage a portion of their portfolio in that way to
create an inflation proof income stream over the very long term, the most reliable asset class is
shares, at least in terms of generating high, consistent, predictable and growing income streams.
However, unlike bond and cash portfolios, where all the assets are relatively homogeneous in the
way they produce an income stream, different shares may have vastly different income and growth
characteristics. Accordingly, the mix of shares (companies) in a share portfolio from time to time can
profoundly affect both its short and longer term prospects.
The next paper will examine some of the strategies to create income streams from share portfolios
in more detail especially looking at the longer term implications of creating an income stream
through a broad portfolio of high yielding stocks or from lower income “growth” stocks.
For more NFP thought pieces, please visit www.harperbernays.com.au/not-for-profit-thoughtpieces.
Hugh Hodges
Director – Philanthropy
Harper Bernays Limited
[email protected]
DISCLAIMER: Harper Bernays Limited has made every effort to ensure that the information contained in this
presentation is accurate. This document is not intended to provide a comprehensive description of the Harper
Bernays’ investment, its investment opportunities or its investment strategies.
Harper Bernays Limited has not taken into account the investment objectives, financial situation or particular
needs of any particular client. Before making an investment decision on the basis of this information, you
should consider whether the information is appropriate in light of your particular investment objectives,
financial situation or particular needs. You may wish to consult external advisers to assist you with your
decision.