Comparing portfolio risks

We’re often asked by our clients to compare portfolios. Usually they have a potential client who has come to them with a portfolio from another adviser or a self directed portfolio, and they want us to give them a detailed view on the difference and similarities between the prospect’s portfolio and a model portfolio to help them form a set of investment recommendations that are backed by strong evidence.

We use a database with over 15 million data points for Australian-domiciled managed funds, and at least as many values for listed equities, to give a thorough comparison of portfolios and identify the key differences. But the biggest challenge is working out which alternative portfolios have a similar risk level to make the comparison fair.

Many fund managers, model portfolio providers and financial advice firms use the standard risk measure framework developed by the FSC and AFSA to provide a measure of risk to compare portfolios. These measures are required for products in superannuation PDSes, and so most fund managers end up calculating an SRM because the trustees of superannuation wraps require them for all funds on the super menu. The SRM is conceptually simple: it’s based on the expected number of negative years that a hypothetical investor could expect in a 20 year period. These map to risk bands with standard labels, although many providers also (or only) provide the expected frequency of negative years.

There are a minor few weaknesses with this framework, in our view:

  • The framework doesn’t distinguish between high and low drawdowns, nor the chance of recovering from a drawdown. Some strategies (like selling options, or securitised debt products) could have rare but deep drawdowns from which they will never recover, but screen as less risky than an equities fund using an SRM.
  • Many investors don’t understand the subtle difference between negative returns over a year (calendar year or financial year, for example) and negative returns within a year or over any 12 month period.
  • The framework was approved in 2011 when safe asset returns were much higher than they are now. So portfolios now are all pushed to the riskier end of the SRM scores.

But the biggest concern is this: the framework guides you on how to calculate the SRM, but each trustee, fund manager or responsible entity is free to come up with their own set of assumptions on risk and return for their investments. One of the big lessons from the debacle around collateralised debt obligations in the GFC is that it’s very risky to let product issuers determine their own input assumptions for these sorts of calculations.

We were recently looking at a portfolio with 70% growth assets and 30% defensive assets, and the provider had self assessed that portfolio as expecting to have 1 negative year in every 8 years. That translates to an SRM of Medium (band 4 out of 7). But using our assumptions we’d classify that portfolio’s risk level as High (band 6 out of 7).

As an exercise, we did a few calculations to estimate how optimistic their assumptions would have to be to get risk as low as the provider had assessed it. We assumed a risk premium over fixed interest of 6% p.a. for Australian and international equities, 5% for property and 4% for alternatives. (Our standard assumptions are similar, but slightly less optimistic than this.) We used historical volatility levels for the risk of each asset class and our standard correlation assumptions, and worked out how high bond returns would have to be to get an average of 1 negative year in 8.

We had to push the expected return on bonds to 5% to get the risk as low as the quoted number. That makes the equity return expectation 11% p.a. Both of these figures are well above long term historical returns of the US, one of the best performing markets, let alone other countries. And right now we are starting from historically high equity valuations and much lower bond yields. Simply put, these assumptions are far too optimistic to be credible. And any adviser relying on them runs the risk of disappointing their clients and giving poor advice.

We’ve found that, for all that past performance is not a reliable predictor of future performance, comparing the historical risk of portfolios is the most reliable way of ensuring that we are making an “apples to apples” comparison of two portfolios. Our standard analysis includes a “backcast” of the returns of a client’s portfolio. This tends to be generous to the portfolio (unless they have rebalanced rigorously, the portfolio will be overweight the best performing investments and underweight the worst performers) but gives a consistent basis for comparison without relying on assumptions.

Important Information: This document has been prepared by Aequitas Investment Partners ABN 92 644 165 266 (“Aequitas”, “our”, “we”), a Corporate Authorised Representative (no. 1284389) of C2 Financial Services, (Australian Financial Services Licensee no. 502171), and is for distribution within Australia to wholesale clients and financial advisers only.

This document is based on information available at the time of publishing, information which we believe is correct and any opinions, conclusions or forecasts are reasonably held or made as at the time of its compilation, but no warranty is made as to its accuracy, reliability or completeness. To the extent permitted by law, neither Aequitas nor any of its affiliates accept liability to any person for loss or damage arising from the use of the information herein.

Please note that past performance is not a reliable indicator of future performance.

General Advice Warning: This document has been prepared without taking into account your objectives, financial situation or needs, and therefore you should consider its appropriateness, having regard to your objectives, financial situation and needs. Before making any decision about whether to acquire a financial product, you should obtain and read the relevant Product Disclosure Statement (PDS) or Investor Directed Portfolio Service Guide (IDPS Guide) and consider talking to a financial adviser.

Taxation warning: Any taxation considerations are general and based on present taxation laws and may be subject to change. Aequitas is not a registered tax (financial) adviser under the Tax Agent Services Act 2009 and investors should seek tax advice from a registered tax agent or a registered tax (financial) adviser if they intend to rely on this information to satisfy the liabilities or obligations or claim entitlements that arise, or could arise, under a taxation law.

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