Undoing the growth/defensive straight-jacket: how risk assessment is changing asset allocation

The proliferation of new types of investments has meant that traditional asset allocation by institutional investors has become so complex that some assets are difficult to classify as either ‘growth’ or ‘defensive’ in nature.

According to Shane Oliver, head of investment strategy and chief economist at AMP Capital Investors, problems in categorising new asset classes means the traditional manner of viewing assets as either ‘growth’ or ‘defensive’ is living on borrowed time. “A superior approach is to categorise assets and investment portfolios in terms of their risk,” he says in his latest letter to clients. He says that, at a very broad level, categorisation of assets along growth and defensive lines has helped provide a rough guide as to their risk, but the weaknesses of this paradigm are becoming increasingly apparent. For starters, traditional government bonds are not as defensive as often thought. 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 therefore total returns in any one year. In 1994, for instance, 10-year bond yields jumped from 6.4 per cent to more than 10 per cent and Australian fixed interest, as an asset class, lost 5 per cent. Now, the defensive characteristics of fixed interest investments are getting progressively “hazy”. With a diminished supply of government debt and low bond yields, fixed interest products increasingly include corporate debt, infrastructure debt and emerging markets debt. The introduction 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. Oliver says property, too, has always been difficult to fit into the growth/defensive categories. In many ways property should be considered defensive, particularly investments with high yields and long leases, but property cash flows are not fixed. Historically, both property and infrastructure have had behavioural characteristics somewhere between bonds and equities. “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,” Oliver says. New asset classes, such as hybrids, often fall between the cracks and may be left out altogether – equity managers regarding them as too defensive and bond managers regarding them as too ‘equity like’. Some investments may get stuck in the ‘other’ category. Should a fund of hedge funds be regarded as a growth or defensive portfolio? Equities do not always do well when economic growth is strong. Periods of high growth and high inflation are usually bad for equities. Oliver says that developments in managing the risk in portfolios shows there is a better way of classifying assets than growth or defensive. This involves determining the riskiness of each asset, setting an overall risk level which is acceptable and then combining a range of assets to achieve that. By trying to, artificially, fit and constrain assets into a growth/defensive “straight jacket”, investors may end up with a sub par outcome in terms of risk and return, Oliver says. “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.”