Absolute return strategies – the ideal portfolio shock absorber

The year 2013 will deliver its share of challenges for superannuation funds as they position themselves amid continuing market uncertainty but, as Standard Life’s Simone Bouch reports, it is often better to take a longer view.

Superannuation funds may be considering their asset allocations and risk exposures as we settle into a new year.

While some funds may tinker at the edges, it’s worth considering what investment markets might do looking forward.

Many superannuation funds have built large cash exposures, but with the expectation that interest rates are likely to fall further this year, allocations away from cash are likely.

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Risk appetite is returning and equity markets are likely to benefit from increased inflows.

However, with volatility ‘bumps’ likely to remain part of the investment landscape, a smooth upward path for equity returns is unlikely… 

So where else can superannuation funds look for attractive investment returns?

In recent years superannuation funds have been devoting more attention to alternative assets such as infrastructure, private equity and absolute return strategies to achieve broader diversification of their assets.

For some funds, alternative assets now represent close to 20 per cent of their strategic allocations. 

A key feature of many multi-asset absolute return strategies is their objectives-based approach to investing, focusing on increasing the absolute level of investor wealth while limiting exposure to capital loss, regardless of market conditions. Importantly, this aligns the manager’s objective with the financial needs of the investor.

Constructing a genuinely resilient portfolio in today’s uncertain environment requires the investment manager to consider many scenarios: a fragile global economic recovery; bouts of high volatility; inflation or deflation fears; emerging markets growth – the list goes on. 

Multi-asset absolute return managers aren’t tied to any central asset allocation benchmark, giving the manager the necessary freedom to select only those underlying strategies and markets they expect to be rewarding.

Returns are typically referenced to a cash or inflation benchmark, allowing the manager to invest across a wide range of opportunities to access the necessary diversification required for delivering on an absolute return objective. 

It is well recognised that the superannuation fund industry is already heavily exposed to equities. According to the Organisation of Economic Co-operation and Development (OECD), Australian superannuation funds had the highest allocations of any OECD country to equities in 2011. 

Investing in a multi-asset absolute return strategy that is dynamic and unconstrained, coupled with true diversification and robust risk management, allows superannuation funds to expect a superior reward/risk payoff compared to conventional long-only equities investment, for example. 

Including absolute return strategies in a portfolio

The question is often asked, what benefit does a superannuation fund achieve by allocating to multi-asset absolute return strategies, and from where should the funds come?

Scenario 1: Improving the risk-and-return trade off

For simplicity, assume a superannuation fund has a portfolio with 50 per cent equities and 50 per cent bonds. In this example the fund is looking to allocate 25 per cent of its assets to absolute return strategies and is considering how much to fund from its equity and bond allocations.

From a governance perspective, the fund is also concerned about making a market timing decision away from equities. 

In this example we consider a multi-asset absolute return strategy that currently has a 20 per cent exposure to equity market beta but the ability to dynamically manage this exposure over time, holding up to 40 per cent equity beta when markets are favourable.

With 20 per cent of the absolute return strategy currently exposed to equity beta, it is possible to maintain the fund’s current equity market exposure by drawing only 5 per cent of the proposed 25 per cent absolute return allocation from equities.

The remaining 20 per cent would be drawn from the bond allocation.

The superannuation fund’s portfolio of assets then becomes 45 per cent equity, 25 per cent absolute return and 30 per cent bonds.

The superannuation fund has now incorporated a strategy that will assist it in dynamically managing the long-term equity weighting of the overall portfolio whilst seeking to achieve a positive return in all market environments.

What impact does the inclusion of absolute return assets have on the superannuation fund’s portfolio? The risk/reward payoff has the potential to improve as indicated in chart 1, increasing the potential return whilst reducing the overall level of risk.

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This improvement is despite reducing the superannuation fund’s bond exposure, which is typically used as a lower-risk asset class.

The addition of the multi-asset absolute return strategy can assist in dynamically managing the asset allocation, forming a bridge between growth and defensive assets.

Scenario 2: Diversifying your asset allocation risk

Diversification has been described as the investment world’s only free lunch. The problem during the global financial crisis, however, wasn’t that diversification failed but that many investors weren’t diversified enough. 

Past academic studies have shown that around 10 per cent of the variability of returns comes from stock selection, yet most superannuation funds spend a significant amount of time and resources diversifying stock selection through the employment of a large number of managers within each asset class. 

Another way to consider using multi-asset absolute return managers would be to take a slice, again for simplicity say 20 per cent of a fund’s total portfolio, and invest this with absolute return managers that think and invest differently.

In doing this you can further diversify your risk budget from 10 per cent to 30 per cent, as illustrated by Chart 2, gaining access to asset classes and strategies that would be otherwise difficult to implement. 

Multi-asset absolute return strategies offer true diversification and seek a target return for the lowest level of risk possible.

They act as ideal portfolio shock absorbers in times of market turbulence without sacrificing returns. 

Simone Bouch is head of business for Standard Life Investments in Australia.