Today's unprecedented market conditions have heightened investor uncertainty. Newspapers are reporting on fears of rising inflation, following a downward trend over the last three decades. Furthermore, central banks suggest that record-low interest rates will rise sooner than previously assumed. These shifts could have dramatic implications for traditional asset classes, with an impact on portfolio risk management.
Some argue that the re-emergence of inflation is structural. Others, including central banks, expect it to be transitionary, forecasting a temporary spike caused by the re-opening of economies as they recover from the pandemic-driven downturn.
Notwithstanding the debate, most professional investment managers agree that market risk is exceptionally high. As cash and bonds are delivering low, if not negative returns, investors have been channelling funds into equities and property, where valuations are historically high but laden with risk.
The significant risks in the market have spurred renewed interest in active portfolio management. The active investment approach has been out of favour for many years, as the long-term cycle of steadily falling inflation has propelled stock prices ever upwards. It was an environment that made it difficult for active managers to outperform a low-cost inactive 60/40 strategic asset allocation that is the default for many financial advisers. The chase for higher relative returns drove risk assets higher.
However, current market dynamics are likely to reverse the cycle by making it difficult for passive investors to generate sufficient returns with prudent risk management.
Active investment managers can react quickly to protect capital while selectively making opportunistic investments to boost returns. Importantly, active managers can more readily diversify by investing in alternative assets, such as derivatives, hedge fund strategies, precious metals and private equity. Alternative assets can offer diversified portfolios superior risk-adjusted returns than if they only use traditional asset classes within an SAA mix. Helping to lessen downside risk not only protects against drawdowns but can also bolster portfolio returns over time.
Passive investment solutions currently have fewer diversification options available, particularly in the alternatives space, limiting their risk management options.
A prime example of successful active portfolio management is found in Dynamic Asset portfolios as used extensively by WLM. Dynamic Asset offers five unique portfolios that target varied returns within pre-determined risk parameters and time frames. The portfolios are managed using a forward-looking approach that is sensitive to market conditions and focuses on uncorrelated strategies and assets. Assets are specifically selected based on their ability to deliver on the return objectives. At the same time, strategies are employed to hedge against excessive risk. It is very different from the passive 60/40 strategic asset allocation approach that exposes capital to the mercy of market movements.
Attention to portfolio risk management plays a crucial role in delivering on return targets. Also, lower portfolio volatility makes investing less stressful. The Prospect theory, developed by psychologists Daniel Kahneman and Amos Tversky, maintains that the distress caused by a loss is psychologically twice as great as the feeling of a win. This is the phenomenon that makes people want to buy when the market is up and sell when the market is down - counter to what actually creates value. Lower volatility and a focus on goals helps investors to stay on track and focused, which can make a material difference to returns over time.
If you'd like help with understanding how active portfolio management can help lessen risk for your Super and other investment, contact us today.
The material and contents provided in this publication are informative in nature only. It is not intended to be advice and you should not act specifically on the basis of this information alone. If expert assistance is required, professional advice should be obtained.