Adjusting portfolios to manage for risk

Funds Management

by Clive Tompkins

MLC's Head of Investments Dr Susan Gosling outlines how the MLC Inflation Plus portfolios adjust the asset mix to manage for risk as assets become cheap or expensive.

Sinead Rafferty: I'm Sinead Rafferty, Portfolio Specialist at NAB Asset Management, and I'm joined by Susan Gosling, Head of Investments at MLC. Welcome, Susan.

Susan Gosling: Thank you, Sinead.

Sinead Rafferty: Markets have performed strongly in recent years. What should investors expect going forward?

Susan Gosling: Yes, over the past six or seven years returns have been well in excess of longer-term averages. And it's tempting to believe, of course, that these returns can continue. But after a period of high returns like this, return potential is often low. This was the case in both 1999 and 2007, and it's the case today.

Sinead Rafferty: Does this mean that risks are elevated?

Susan Gosling: Yes. When share prices rise faster than earnings, they are factoring in future good news -- future returns are being brought forward. So, this means that, looking forward, return potential is lower, and there's increased risk if the future does not turn out as positive as assumed.

Sinead Rafferty: How does that affect portfolio positionings?

Susan Gosling: Our forward-looking scenarios framework builds insight into how return potential and, most importantly, the risk of significant negative returns, changes through time. We position portfolios on the basis of what's sustainable, recognising the vulnerabilities of asset prices rising too fast.

Sinead Rafferty: How does this change the pattern of returns?

Susan Gosling: When returns are strong but risk is high, Inflation Plus will lag traditional benchmark relative funds, but when asset prices fall, Inflation Plus is more resilient. This gives a smoother path of returns -- lower volatility and higher risk-return efficiency because of greater investment degrees of freedom. This means that, on average over a full cycle, Inflation Plus can have lower volatility but not necessarily lower returns.

Sinead Rafferty: Volatility has been higher recently. What were the drivers behind this?

Susan Gosling: Early in the year, stronger than expected wages data resulted in a sharp interruption to the share market’s seemingly inexorable rise. This rise in volatility was a reminder of underlying fragilities that have accumulated in the financial system. The origins of this are excessive levels of debt, which lay behind the global financial crisis and are still unresolved. Now, central banks have offset the deflationary impact of this debt with ultra monetary accomodation -- so, very low rates and quantitative easing. This environment of excess liquidity has changed behaviour. It's progressively pushed investors up the risk spectrum, making most assets expensive at the same time. The vulnerabilities are at least as much in bonds as in equities.

Sinead Rafferty: Central banks are changing their monetary policy settings. How might this play out?

Susan Gosling: Yes, monetary policies are starting to reverse. US cash rates are rising, and, on current expectations, by the end of the year, US cash may have a positive real return for the first time in a long time. The return of cash as a safe haven may tempt investors to start moving back down the risk spectrum. And we are only at the beginning of this process. As monetary policy changes direction, eventually also so too does the perception of abundant savings. The belief that weight of money will support asset prices may yet be revealed as an illusion.

Sinead Rafferty: And, lastly, Susan, what are the most main messages for investors today?

Susan Gosling: I think that we should not deceive ourselves about how uncertain returns are looking forward.
We can, of course, hope that the returns will stay strong, and they may for some time yet, but this is a gamble which at some point will not pay off. We cannot be entirely sure how all of this will play out, but there are clear vulnerabilities to asset prices inflated by the presumption of low rates and easy money. So, it seems timely for investors to ensure that they understand how much investment risk they are taking, and consider carefully their risk tolerance. Taking a more defensive approach can mean that you give up returns if markets continue to rise. However, that can be the price of protecting lifestyle outcomes.

Sinead Rafferty: Thanks for your time, Susan. And thank you for joining us.