Market turbulence has put the performance of superannuation plans under the spotlight, and rightly so. If volatility is a proxy for risk, then risk most certainly has increased in recent months.It is to be expected that the guardians of our retirement assets should be working hard to identify and understand all of the risks embedded in investment portfolios. Perhaps they should also be looking for those risks they can take advantage of to generate good riskadjusted returns. I would like to suggest four questions that all trustees should be asking their investment committees. one: are you diversified? The theme of diversification is not new to any of us. It is a key strategy to reduce risk. However achieving diversification is not always as straightforward as it sometimes seems. It is worth asking ourselves the following two questions: Are our portfolios as diversified as we think they are? Is it enough to just hold a broad range of asset classes in your portfolio?

The answer to both questions is: probably not. The risk of extreme negative returns in many asset classes is higher than implied by the normal distribution, and higher than many investors might expect. This is particularly true during periods of high volatility. In figure 1, the blue line represents the frequency with which each level of return has been observed for the MSCI World Index since December 1999. The red line represents the normal distribution typically assumed in traditional methods of portfolio construction, using the same average return and volatility. At the lower left side of the chart, the blue line is significantly above the red line. This means that large negative returns have occurred with a significantly higher frequency than is assumed by the normal distribution. The systematic underestimation of downside risk by the normal distribution is by no means confined to global equities. The chart looks similar for a number of asset classes.

It is the statistical demonstration of what many investors will have observed in their own portfolios over the past decade, namely, that extreme losses such as those seen in 2002 and 2008 happen more frequently and with greater magnitude than traditional ways of measuring portfolio risk may imply. Another important aspect of diversification is the extent to which an apparently diversified position can turn concentrated in times of market stress. This is another way of saying that correlations between asset classes tend to increase when price movements are extreme. Measuring the relationship between asset classes using just correlation ignores the true “shape” of relationships. More accurate techniques, such as a method known as copula theory, can be used to understand the relationship between asset class returns more completely. The best way to deal with the matter is to ensure that assets are truly diversified. Within each broad asset class, this means it is important to ensure that returns come from as broad a range of sources as possible. In equities this means considering not just global developed market equities, but also emerging market equities as well.

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