This article is from the Australian Property Journal archive
A quiet revolution is underway in investment management that will dramatically change the way asset classes are thought about and how investment strategies are put together. For many years it has been standard practice in the investment management industry to pigeonhole all asset classes into two categories: growth or defensive. Growth investments include equities, property and private capital. Defensive investments include fixed interest (bonds) and cash.
Flowing from this it is common to define multi asset investment strategies, whether via diversified funds or via separately assembled portfolios, based on their mix of so-called growth and defensive assets. For example, diversified strategies or funds with the standard 70%/30% growth/defensive mix are called growth funds. Those with an 80%/20% growth/defensive mix or higher are given titles like high growth or aggressive, while those with a 40%/60% mix or less are called conservative.
However, while this approach has been useful over the years it is now subject to increasing challenge. Concerns about the growth/defensive categorisation have been around for a long time. In fact, we first looked at this issue four years ago. Since then, the challenges have grown.[1]
Problems with the growth/defensive paradigm
At the core of the traditional growth/defensive categorisation is the observation that defensive assets depend on yield (or income) for the bulk or all of their return, whereas growth assets have a greater reliance on capital growth. Thus, the low reliance on capital growth for defensive assets should mean their returns are less volatile over time. Furthermore, in times of strong anticipated or actual economic growth when capital values for assets like shares and property appreciate, they may expect to outperform defensive asset classes. Likewise, in times of poor growth when capital appreciation is weak or negative, defensive assets might do best.
So, at a very broad level, the categorisation of assets and investment strategies along growth and defensive lines helps provide a rough guide as to their risk.
However, the weaknesses of the growth/defensive paradigm are becoming increasingly apparent.
· Firstly, traditional government bonds are not as defensive as often thought. Many people think of fixed interest as being a bit like a term deposit – ie, with a fixed interest rate and a fixed value that is returned at the end of the term. In reality, fixed income investments are subject to market fluctuations in interest rates and bond yields. Relatively modest changes in yields can produce big swings in capital values and hence total returns in any one year. The lack of “defensiveness” of fixed interest investments in this regard was highlighted in 1994 when ten year bond yields in Australia rose from 6.4% to over 10% and Australian fixed interest lost 5%.
· Secondly, the defensive characteristics of fixed interest investments are getting progressively hazy with changes in what is called fixed interest. It used to be just government debt. Now with a diminished supply of public debt in Australia and with low government bond yields pointing to low prospective returns from such bonds, fixed interest products increasingly include corporate debt, infrastructure debt and even emerging market debt.
Here the risks change significantly. The key point is that sovereign debt is (in developed countries) regarded as credit risk free – the government will always pay you back (even though it may be in deflated currency). By contrast, the introduction of private sector debt has introduced a significant component of credit risk into fixed interest portfolios – corporate debt may rank above equity but you can still lose all or a significant part of your investment in the event of a company failure. The introduction of corporate debt necessarily implies a greater exposure to the economic cycle. The use of hybrid securities (such as convertible notes) is further blurring the distinction between debt and equity and introducing an element of growth to fixed interest portfolios. And, the use of emerging market debt introduces a significant degree of risk.
· Thirdly, it has always been difficult to fit property – whether listed or unlisted – into the growth/defensive split. In many ways property should be considered a defensive asset, particularly high yield property with long leases. In broad terms property does have a number of “fixed interest-like” characteristics. Both require an initial investment, have periodic cash flows and a terminal value. Unlike a government bond though, property cash flows are not fixed (although the longer the lease term the more “bond like” the cash flows become). Likewise, the terminal value for property is variable.
These considerations also apply to other assets like infrastructure. It is worth noting that historically both infrastructure and property have had behavioural characteristics somewhere between bonds and equities. Reflecting the importance of income or yield in their total return they have tended to be either lowly correlated to equities (in the case of unlisted property and infrastructure) or have a relatively modest correlation to both equities and bonds (in the case of listed property). Either way they are a good diversifier.
Thus, with property and infrastructure having “bond like” characteristics and with fixed interest portfolios taking on a higher exposure to credit risk and growth, the simple classification of bonds as defensive and property as growth has lost any meaning.
· Fourthly, new asset classes, like hybrids often fall between the cracks and can be left out altogether with equity managers regarding them as too defensive and bond managers regarding them as too equity like. There are other assets that often get stuck in the “other” asset category. For example, should a fund of hedge funds or what is increasingly called absolute return strategies (where any market exposure has been stripped out as far as possible with the use of futures contracts) be regarded as a growth or defensive portfolio? Many would argue it is not growth but it is certainly not defensive either. As such it either gets left out of the growth/defensive classifications or it is arbitrary as to how it is classified.
· Finally, it should be noted that equities don’t always do well just because “growth” is strong. Periods of high growth and high inflation are usually bad for equities given the pressure it puts on interest rates. In fact, when this is the case direct property investments normally perform best.
A better way – defining assets in terms of risk
Developments in managing the risk of investment portfolios shows there is a better way than the growth/defensive approach to classifying assets and investment portfolios. This is to focus on their risk level. For a multi asset diversified fund this involves determining the riskiness of each asset, setting an overall risk level that is acceptable and then combining a range of assets to achieve that unconstrained by the growth/defensive straight jacket. The following table shows medium term (taken to be five years) return and risk assumptions for the main asset classes.[2]
Medium term risk and return projections, %pa
|
|
Return
|
Risk
|
|
Global Equities, in $A’s
|
8.0
|
13.0
|
|
Australian Equities
|
9.9
|
13.5
|
|
Unlisted Property
|
9.5
|
9.0
|
|
Aust Listed Property
|
8.9
|
10.5
|
|
Global Listed Property
|
8.9
|
10.5
|
|
Unlisted Infrastructure
|
10.0
|
10.0
|
|
Aust Bonds
|
5.4
|
4.5
|
|
Aust Cash
|
5.5
|
0.5
|
Source: Thomson Financial, AMP Capital Investors
The following chart compares the expected risk and return from a standard 70%/30% growth/defensive mix of assets, usually called a “growth fund” or “growth strategy”. It is compared to combinations of the above assets unconstrained by the growth/defensive straight jacket, for various levels of risk. This is shown as the curved line, or what is known as an efficient frontier because it shows the combination of assets providing the highest level of return for each level of risk.
Source: AMP Capital Investors
The point is that the constrained growth/defensive approach results in a less than optimal portfolio. A higher expected return can be obtained for the same level of risk (portfolio A) or the same expected return can be obtained for a lower level of risk (portfolio B). So, by trying to artificially fit and constrain assets into a fixed growth/defensive straight jacket, investors may end up with a sub-par outcome in terms of risk and return. A better approach would be to determine a level of risk that is acceptable and then choose a combination of assets designed to achieve that goal. It is likely the investment management and financial planning industry is heading in this direction.
Conclusion
The growth/defensive categorisation of assets and investment strategies has proved useful for the investment management and financial planning industry over many years. However, growing difficulties in categorising existing assets and particularly new asset classes into the growth and defensive boxes along with advances in risk management suggest it is living on borrowed time. A better approach is to focus on the expected risk level of assets and investment strategies.
By Dr Shane Oliver, head of investment strategy and chief economist with AMP Capital Investors.*
