Errol Woodbury of Woodbury Financial Services says the global financial crisis exposed flaws in the traditional investing model. Photo: Rob Homer

Bina Brown

How do you make better returns without taking an uncomfortable level of risk? Its a perennial question, but the answer might not be the one we have been trained to expect.

Having witnessed firsthand during the global financial crisis that diversification across the traditional asset classes of equities, fixed income, property and cash wont protect against a financial market meltdown, investors desperately want to level out the volatility but still get positive returns.

Its a brave new world when it comes to investing, says Woodbury Financial Services principal adviser Errol Woodbury. New problems require new thinking, new opportunities require a new strategy. We cant keep doing the same old things the same old way and expect a different outcome.

He says the financial crisis demonstrated that if we want more certainty around outcomes, we will need a new approach to managing money.

Strategic asset allocation is still applicable for investors who are less sensitive to peaks and troughs, and still wanting a lower-cost solution compared to the real return funds, Woodbury says. But as more people move into the retirement phase [pre and post], they are more sensitive not only to the outcomes they need, but to the journey it takes them on and where their wealth ends up.

Absolute and real returns

So what are the options?

Absolute return and real return funds are two in the spotlight. Absolute return funds aim to deliver returns in both rising and falling markets, investing in a wide range of asset classes and employing various investment strategies.

While not new, real return funds are difficult to define but work in a similar way. The formalisation of a group of advisers and fund managers focused on real return investing is fuelling discussion about whether traditional asset allocation is the best way to manage volatility and other risks.

The adviser-led Association of Real Return Investment Advisers (ARRIA) plans to bring anyone in the wealth management industry who is interested together every quarter to discuss real return strategies, including long-short equity, event-driven and managed futures.

High on ARRIAs agenda is defining exactly what real return investing is.

Broadly, says ARRIA general manager Philip Reid, it uses non-traditional strategies aimed at providing income and capital appreciation and preservation. When combined with traditional asset classes, it has a shock absorber effect, he says.

If you want to sit and wait, then you can pick any period in history and make a case that equities are a good thing, Reid says. The reality is, if you are withdrawing money, then you could be pulling it out of a lower balance.

A 50 per cent drop in the value requires a 100 per cent increase to get back to where it was, which may be impossible in a short time frame.

Real return investing is achieving diversification in risk, not just in assets, Reid says. If you are long only equities and long bonds, then the long only equities represent 90 per cent of your risk. If you are in a balanced superannuation fund and you look at the sharemarket, then that is pretty much what your portfolio will be doing.

Reid believes that while diversification is key to real return investing, the assets in a portfolio should have low correlations.

The less correlated the assets are in your portfolio, the more efficient the trade-off between risk and return, Reid says.

Investors approaching 2007 with what they thought was a diversified portfolio across the major asset classes, including equities and bonds, quickly discovered these were highly correlated and all went down together.

Appetite for risk dictates portfolio

Northstar Financial Advisers principal and ARRIA member Alistair Saunders has been offering his clients a multimanager approach to strategic asset allocation for three years, with a mostly positive response.

We build a portfolio to suit a clients appetite for risk, rather than accept that assets will jump around, he says. There might be six categories of equity exposure in a portfolio but each manager will use a different strategy to reduce risk.

When you consider a typical balanced portfolio has 95 per cent equity risk and you show clients that different risks over time means that returns are going to be more consistent, then adding some extra pieces to a portfolio becomes commonsense.

Ratings agency Zenith this year established a dedicated category for the growing number of real return strategies.

Zenith senior investment analyst Andrew Yap says members of this category seek to produce inflation-adjusted returns over the longer term by permitting the investment manager to alter a funds asset allocation in response to changing market conditions.

Such an approach is in contrast to the conventional strategic asset allocation only approach, which references a predefined asset mix and has shown to have limitations in more volatile markets, owing to its greater reliance on the assumptions of mean-reversion and normality, he says.

Yap says many real return funds have material exposure to unconventional assets (including illiquid assets) and use strategies such as leverage and shorting, which come with their own risks.

AMP Capital head of investment strategy and chief economist Shane Oliver believes the traditional allocation to major assets of equities, property, bonds and cash remains as critical as ever but it is how it is done that counts.

The idea of a set-and-forget approach to investing across the major assets may work for those with a long-term horizon, of say 40 years, but the closer one gets to retirement, the more dynamic ones approach to investing may need to be, including incorporating real return investing, he says.

Oliver notes that approaches to asset allocation tend to combine long-term strategic allocation and short trading-focused tactical asset allocation into what is increasingly called dynamic asset allocation.

An advantage of this dynamic asset allocation approach is that it can be entirely implemented via highly liquid futures, exchange-traded funds or index funds, and can replicate a diversified mix of assets for a fraction of the cost but with more flexibility in varying the asset mix than in a traditional fund, Oliver says.

The power of the cycle

Oliver says two fundamental truths are relevant to every investor. One is the power of compound interest, the other is there is always a cycle. Over long periods of time you will do better in growth assets such as property and shares and, therefore, if you are just entering the workforce, or even aged 40, you will find that over all 20-year time horizons, shares will do better. So you can make an argument that people should choose the all-growth option and shouldnt worry about it too much, he says.

The problem and the opportunity is that there is always a cycle.

It doesnt matter for a young person, Oliver says. But the cycle throws off people who are close to or into retirement. They dont get the benefit of compound interest like higher returns from shares.

Furthermore, investors close to retirement or retirees often wait for the bad times to hit then switch from high-growth strategies into conservative options and even cash.

Then after a couple of years, when things swing the other way, they get back in but they have missed the benefits of compounding. Market cycles can also create opportunity, which is why asset allocation is valuable.

In extremes, you can move the asset mix to take advantage of when markets are overvalued to protect value on the downside and, when undervalued, to buy into them, Oliver says.

Success depends on the amount of time investors are prepared to spend researching and acting on the possibilities. Beyond the critical assets of equities, property, bonds and cash are the derivatives of those assets which require a greater understanding.

Corporate debt is a function of government bonds and the equity market, he says.

Infrastructure is similar to property. Hybrids can be a mix of debt and equities. Then you have onshore and offshore assets and at various times it make sense to be invested in different markets.

You do get diminishing return to effort the further you get away from the main assets.

This is where advice from a trusted professional and or handing your money to professionals can make sense.

Unless you are prepared to put in the effort, I usually say you are better off taking the indexed approach or investing in a fund that undertakes the asset allocation, Oliver says.

The post-GFC world has changed

Of course, it doesnt have to be an all or nothing approach. As peoples lives change, so can their investments.

Woodbury says that in the post-GFC world, it is even more important to understand the characteristics of assets and how they behave in different circumstances. Then look at what strategies you can include in your portfolio to avoid nasty surprises, he says.

With risk firmly back on the agenda, we need to keep an eye on how assets perform in different periods, Woodbury says. We stress-test how client portfolios will behave against extreme economic circumstances, make sure they are comfortable with the outcomes and then build a portfolio around the best way to achieve their real-life returns.

Woodbury notes that as well as some investors becoming more risk averse, Australias ageing population has increased the need for reliable returns. We need to think more laterally on portfolio management, he says.

Asset allocations that dont change with the environment may not provide the income or returns an investor needs.

Woodbury says the focus should be on how much income clients will need and how much risk they can bear.

Deloitte wealth management leader Neil Brown agrees there is a place for multiple investment tactics depending on a persons life stage. It comes down to some very simple principles, which is understanding what the investor wants and then constructing a portfolio that meets their needs, he says.

The other thing to remember is that anything that has a mechanism that protects on the downside comes at a cost, Brown says.

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