Download An introduction to diversification by risk factor PORTFOLIO INSIGHTS

PORTFOLIO INSIGHTS
Investment risk management insights
for professional financial advisers
May 2016
Intelligent investing: An introduction to
diversification by risk factor
This edition, the second instalment in a
two-part series on diversification, takes
a closer look at the underlying risk factors
in shares, bonds and property
Last month’s edition of Portfolio Insights took a high level
look at diversification and risk management.
In this edition, we drill down further and consider how
investors can achieve a truly diversified portfolio by
intelligently managing their exposure to the various
underlying risk factors within each asset class.
We’ve chosen to focus on shares, bonds and property,
however, every asset class is exposed to specific
risk factors.
Shares
Many people think that a well diversified share portfolio
is one that’s invested across different sectors,
e.g. materials and energy, financials, retailing,
and telecommunications.
But that’s a very limited and crude approach to
diversification.
It’s far more effective and intelligent to diversify by
risk factor.
Within every asset class there are underlying risk factors.
In shares, there are companies trading at a discount
to the market (value stocks), companies that are more
profitable than the broader market (quality stocks), and
companies with lower volatility (lower beta stocks).
There are also companies with strong momentum.
Investors can also diversify by size given quality smaller
companies tend to outperform large companies over the
long term.
Let’s look at three of those factors in more detail. For
Valuation of the market and market sectors, Innova uses
a proprietary normalised earnings figure to measure price
to long-term earnings trend.
However, for those who want to do this at home, a basic
proxy is a company’s price-to-book ratio (which is publicly
available information). Price-to-book ratio effectively
compares a company’s share price to its
book value.
Innova’s approach then forecasts reversion to long term
trend over a specified period depending on the prevailing
and forecast market regime. However, a simple method
is to rank companies based on price-to-book ratio and
invest in the top quartile (i.e. the 25 per cent of companies
with the lowest price-to-book ratio) to create a value tilt in
the portfolio.
This is similar to the approach taken by Value investors
the world over, and a way to execute the strategy
in your own portfolio without paying large fees to
external managers.
Investors who want to lift their exposure to quality stocks
can rank companies based on factors like earnings per
share, return on equity and low leverage. (Again, all
publicly available information.)
May 2016 – Intelligent investing: An introduction to diversification by risk factor
Innova Asset Management Pty Ltd
PORTFOLIO INSIGHTS
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Similarly, those keen to lower a portfolio’s volatility may
rank stocks according to their volatility and then invest in
more companies with greater price stability.
These three investing methods have traditionally
delivered higher returns than the broad market:
In addition, diversifying in this way delivers a more
defensive portfolio. Interestingly though, not all factors
perform well at the same time and so blending them
together is what leads to higher returns with less risk.
This is illustrated in the performance chart at the bottom
of the page.
Index Performance (AUD)
MSCI Australia IMI Index
MSCI Australia IMI Quality Index
MSCI Australia IMI Minimium Volatility Aud Index
MSCI Australia IMI Value Weighted Index
4,000
3,500
3,000
2,500
2,000
1,500
1,000
500
0
2000
2002
2004
2006
2008
2010
2012
2014
2016
2010
2012
2014
2016
Source: MSCI Australia
Relative Performance
MSCI Australia IMI Quality Index/MSCI Australia IMI Index
MSCI Australia IMI Minimium Volatility Aud Index/MSCI Australia IMI Index
MSCI Australia IMI Value Weighted Index/MSCI Australia IMI Index
130
125
120
115
110
105
100
95
90
2000
Source: MSCI Australia
2002
2004
2006
2008
May 2016 – Intelligent investing: An introduction to diversification by risk factor
PORTFOLIO INSIGHTS
Innova Asset Management Pty Ltd
3
Bonds
When it comes to fixed income, the two key risk
factors are duration, or interest rate risk; and credit, or
counterparty risk. Investing in a diversified portfolio of
bonds of varying duration and credit rating can minimise
interest rate and counterparty risk.
Investors shouldn’t be put off by the term ‘duration’. An
easy way to understand the concept of ‘duration risk’ is
to consider a three-year term deposit with a fixed interest
rate of 2.65 per annum. During that time, there’s a risk
that interest rates will rise, meaning investors will receive
a lower rate of return than the prevailing market rate over
that three-year period i.e. instead of getting 2.65 per cent,
they could have received a higher rate. Locking your
money up for three years at a fixed rate means that you
should be compensated for this risk. That’s duration, or
interest rate risk.
The degree of an investor’s exposure to interest rate risk
is directly related to the length of time, or duration, of
their bond’s fixed term. Investors should be adequately
compensated for interest rate risk.
Furthermore, duration risk is closely linked to inflation risk
because higher inflation typically leads to higher interest
rates. Credit risk is the other major risk factor in bond
investing. Again, investors shouldn’t be confused by the
term credit. In short, it’s about the quality of the company
an investor is lending money to, which is why it’s often
called counterparty risk.
While it’s often assumed that buying a highly-rated bank
bond or government bond is risk free, in other words,
there’s zero chance of the counterparty defaulting,
there are no guarantees. When an investor lends to any
counterparty, there’s always a possibility they won’t get
the full amount of their capital back.
They should be adequately compensated for taking on
that risk.
being leased to businesses, and businesses being reliant
on a functional and growing economy). These last two are
both loosely linked to inflation.
Given that inflation, GDP growth and demand for land
are all generally positive throughout time, investors are
generally compensated for the risk they take on with one
BIG caveat – provided they don’t overpay!
Property investors who are experiencing gains of around
15-20 per cent per annum should be very wary. Your
house doesn’t keep rain off your head 20 per cent better
per annum, and business profitability across the economy
doesn’t grow at 20 per cent per annum – so why should
the value of the properties?
The importance and value of diversifying
by risk factor
How much or how little exposure an investor should
have to different risk factors will depend on their financial
needs and objectives, and their capacity and tolerance for
risk. Each risk factor carries differing degrees of risk. For
example, the credit risk of an Australian government bond
is significantly lower than the duration risk of a 100-year
Irish government bond.
But we’ve by no means exhausted the number of risk
factors investors are exposed to.
For example, those who outsource portfolio construction
and investment management to an external research
house, asset consultant and/or fund manager are also
exposed to manager skill.
In return for taking that risk, they should be compensated
in the form of higher returns.
While the popular adage ‘Don’t put all your eggs in one
basket’ is true at the individual security level and asset
class level, it’s also pertinent at the risk factor level.
Sophisticated investors should think intelligently about
diversification and diversify across a range of risk factors.
Property
The other obvious asset class to consider is property.
When it comes to residential property the main risk factor
is supply and demand of land exposure and housing
availability while in commercial property it’s domestic
GDP growth and productivity (due to commercial property
Having said that, building and managing an intelligently
diversified portfolio is very difficult to do and monitor
on an ongoing basis because whenever an underlying
asset’s price changes (which is pretty much all the
time), the risk attached changes. That’s why it’s critically
important to seek professional advice.
May 2016 – Intelligent investing: An introduction to diversification by risk factor
Innova Asset Management Pty Ltd
PORTFOLIO INSIGHTS
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Important Information
This document has been prepared by Innova Asset
Management Pty Ltd, ABN 99 141 597 104, which is a
Corporate Authorised Representative of Fortnum Private
Wealth Pty Ltd, AFSL 357306.
Dan Miles is Managing
Director of Innova Asset
Management. Innova is a
boutique asset consultant
that advises on and
implements asset selection
and allocation, trade and
execution, and manager
selection for the Innova
Managed Accounts.
The performance reporting in this document is a
representation only. Innova Asset Management has
used a calculation methodology to simulate the
performance of the relevant investment program
as constructed by Innova Asset Management since
commencement, net of all fees and commissions at
the Fund/security level, and assumes monthly and
quarterly rebalancing.
Simulated performance does not reflect the performance
of any specific account; each account will have its own
unique performance history, potentially with varied
methods of implementation, fee and tax structures.
Therefore, an individual account and a particular trading
portfolio may have realised varied results from what the
simulated performance indicates.
This report is based on the specified model portfolio
without change. Other model portfolio results will vary.
This report does not apply to the results of any other
model portfolio.
Innova Asset Management Pty Ltd
ACN 141 597 104
3/36 Bydown Street
P.O. Box 1899
Neutral Bay NSW 2089
Phone: 02 9346 4656
Fax: 02 9953 5668
www.innovaam.com.au
This is not an offer of securities or financial products
nor is it financial product advice. This document has
been prepared without taking into account your
individual objectives, financial situation or needs. Neither
Innova Asset Management nor Fortnum Private Wealth
guarantees the performance of the Investment Program
or the repayment of capital invested. Investments
are subject to investment risk, including possible
delays in repayments and loss of income and principal
invested. Past performance is not a reliable indicator
of future results.
Although non-Fund specific information has been
prepared from sources believed to be reliable, we offer
no guarantees as to its accuracy or completeness.
Any performance numbers are not promises of future
performance and are not guaranteed. Opinions
expressed are valid at the date this document was
published and may change. All dollars are Australian
dollars unless otherwise specified.