Balanced super funds require greater diversification against macro economic 'Mega Risks' says Russell Investments’ advice business
New Russell research explains how inflation and other macroeconomic risks can weigh on portfolio performance - and how super funds can better protect their assets
MELBOURNE/SYDNEY, 22 July 2008 –Typical balanced Australian superannuation (super) funds are vulnerable to performance ‘shocks’ because they are not properly diversified, too concentrated in financial assets and dominated by equities, according to a major new research paper by leading investment consultant Russell Investments. The key recommendation is that super funds should look to protect themselves from these ‘shocks’ by diversifying away from equities towards other assets.
Speaking at a Russell Research Roundtable for clients in Melbourne today, Dr Geoff Warren, Russell Director of Capital Markets Research, and author of the paper titled “Is Your Portfolio Adequately Diversified?”, discusses how ‘traditional’ super portfolios are heavily exposed to financial assets (around 90 per cent) such as equities and bonds. Furthermore, their equity exposure alone has accounted for well over 90 per cent of return volatility of ‘growth’ super funds during the last 18 years. The paper details how this structure leaves these portfolios particularly susceptible to three macroeconomic ‘mega risks’: 1) economic conditions; 2) profit-share of income; and 3) inflation.
Dr Warren commented on how the three ‘mega risks’ can impact super funds’ performance over the long term. “Fluctuations in the broad economy have an important influence on the performance of ‘traditional’ portfolios for two reasons. First, the economy influences the total income and hence returns arising from the combined pool of assets. Second, such portfolios are dominated by an asset class that is particularly sensitive to economic conditions, i.e. equities,” he said.
“Portfolios that are invested in a subset of all available assets can be exposed to fluctuations in the share of income accruing to the assets they hold. Portfolios therefore that are dominated by equities face the risk of adverse shifts in the profit-share, and its influence on company earnings.
“Moreover, the performance of financial assets such as equities and fixed income has historically suffered under higher inflation, suggesting that rising inflation is a key risk for any portfolio that is heavily weighted to financial assets,” he said.
The paper observes that super funds’ exposure to these factors has been beneficial in the largely benign environment of the last 25 years. The research also talks about how investors who backed solid economic growth, improving corporate profitability and ebbing inflation over this period ‘won the trifecta’, but that these benign conditions may not persist. “There is no guarantee that such a favourable environment will continue. It seems prudent to do what is possible to establish portfolios carrying less of an implicit concentration of bets.”
“Investors should be looking for assets that reduce the exposure to mega risks in their portfolio. However, risk reduction is not the only consideration. The implications for returns should also be considered, given that lower risk assets may be associated with lower expected returns,” Dr Warren said.
Risk deflectors
Dr Warren asserted that that there are two important strategies that super funds can use for setting properly balanced portfolios without necessarily sacrificing expected returns. “Funds should look for ‘switches’ that diversify risk, which involves moving towards assets that offer comparable expected returns to existing assets, but have lower exposure to one of the mega risks. Examples of the kinds of assets that might be substituted for equities include unlisted commercial property, residential property, infrastructure assets, and commodities.
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