In the long run

The Exchange

David Norman explains how assessing risk is one of the most important aspects of any investment decision.

The information contained in this page is for professional Financial Adviser use only.

Most advisers and planners will be using a risk profiling tool to assist with their investment decision making for clients. In simple terms there are two discrete steps: first to assess the risk profile of the client (attitude to risk, capacity for loss, need for return over inflation etc.), then to match this risk profile with a suitable asset mix.

Risk tools typically use some form of optimisation model (e.g. mean variance optimiser) to construct an efficient frontier from which the risk and return can be derived. The tools use long term asset class return, volatility and correlation assumptions to attempt to build the optimum portfolio for each level of risk (as measured by volatility).

The assumptions used by most optimisers are based on some form of historic data – long term return data for example. These may be adjusted for expected future returns to make them more forward looking than just backward facing.

There are many criticisms of these models – that they are backward looking, that volatility is a poor proxy for risk – but there is also wide acknowledgement that they represent the best available option. It is also true that most optimisers have some form of additional adjustments applied to their results, otherwise poorly diversified portfolios or portfolios which are commercially unacceptable may result.
Clearly the data that is used as inputs to these tools is critical to the output. Small changes to long term return assumptions can make substantial asset class changes for a given risk profile. There is also concern that liquidity risk is growing (particularly in bond markets) and that models do not take this into account at all. History also tells us that assets tend to be more correlated in times of market stress – just when it is most needed (probably linked to the lack of liquidity).

It is also important that advisers understand whether the optimiser outputs are real (after inflation) returns or nominal.

The elephant in the room.

Before 2008 inputs to models were straightforward "long term equities beat bonds". A balanced portfolio would therefore likely be skewed to equities - probably a 60:40 split in favour of equities.
This would have been validated by the Barclays Equity Gilt Study 2014 (using 2013 data) (real annual returns %pa, after inflation) for UK asset classes.

2014

 

 

 

 

 

 

2013

10 years

20 years

50 years

114 years

UK Equity

17.4

5.0

4.1

5.5

5.1

UK Gilts

-9.6

2.5

3.5

2.5

1.2

UK Corp Bonds

-1.0

1.8

 

 

 

UK Index Linked

-3.9

2.7

3.2

 

 

Cash

-2.3

-0.5

1.3

1.5

0.8

Using 10, 20 or 50-year data would have seen the higher risk portfolios seeking the higher volatility and higher returning asset classes – equities.

The issue is that these long-term returns were already being undermined by higher returns from bonds (post financial crisis) as interest rates and bond yields fell and stayed low, and from the impact of Quantitative Easing (QE).

The excellent returns in bonds over the last 10 years (since the credit crunch) driven by ever falling yields, has now tipped the return balance over 10 and 20 years in favour of Gilts over Equities. While the very long data, over 50 years, still shows equities having higher returns.

This data below shows the real (after inflation) annualised returns %pa for various UK asset classes over different time periods. source: Barclays Equity Gilt Study 2017 (2016 data):

2017

 

 

 

 

 

 

2016

10 years

20 years

50 years

114 years

UK Equity

13.5

2.5

3.7

6.0

5.1

UK Gilts

8.7

4.3

4.5

3.1

1.4

UK Corp Bonds

9.5

3.1

 

 

 

UK Index Linked

16.6

4.3

4.4

 

 

Cash

-2.1

-1.3

0.6

1.3

0.8

A balanced investor 10 or even 20 years ago would have been advised into the wrong portfolio – risk models would have shown an equity skewed portfolio being optimum, when in fact a higher returning portfolio (with less risk) could have been achieved by a higher bond weighting.

This would indicate that using a long term strategic asset allocation as a benchmark and applying a medium term tactical overlay could be a good outcome. The ability to tilt away from the strategy benchmark based on medium term valuations (rather than short term "fiddling") could add value so long as the costs would be relatively low.

All change?

Using current data would seem to suggest that bonds, as the higher returning asset class, should be the dominant holding in a portfolio. Yet with the rising spectre of inflation, bond yields at historic lows, and concerns over bond market liquidity this could be exactly the wrong thing to be recommending.
The falling bond yields has seen a boost to CETVs and cautious funds performing exceptionally well. Time will tell whether the excellent returns on bonds can continue.

A low cost well diversified portfolio continues to be an excellent solution for many clients. And risk, particularly risk forecasting remains a very risky business!

Please note, Ascentric and its agents or representatives do not endorse or in any respect warrant any third party products or services by virtue of any advertisement, information, material or content referred to, or included on, or linked from or to this page.

The information contained in this page is for professional Financial Adviser use only. If you are a private investor, please visit the Private Investor section or contact your Financial Adviser for more information.

Back to The Exchange.

Call our sales team

The Ascentric Wrap platform is available for Financial Advisers to support their business. Find out how we could help add more value for your clients

01225 787 575

We're here to help

If you're already using our platform and have a question, please visit our Contact Us page for the best ways to get in touch.