Investment Idea :
New ways to manage portfolio risk
Given the recent melt down in global equity markets, the old principle of not putting all your eggs in one basket has been severely tested during the past couple of weeks. The theory goes something like this: a well-diversified portfolio containing global stocks and bonds should withstand market turbulences relatively better than a portfolio holding just one or two stocks. Unfortunately, there are times when diversification seems to lose its effect. During the first three weeks of January 2008, for example, stocks fell worldwide when America’s credit crunch threatened to drag the whole global economy into a nasty recession.
In recent years, such episodes have prompted more investors to explore so-called alternative or non-traditional asset classes. This category includes commodities, real estate, private equity and hedge funds. Each can help to further diversify a portfolio, potentially improving its risk and return characteristics. That is to say, by adding non-traditional assets to an otherwise traditionally composed portfolio i.e. stocks and bonds; investors can earn a higher return for a given level of risk. Alternatively, they can get the same return for less risk. Please see Chart 1 & 2 below.
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Chart 2
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By investing in stocks and bonds alone, the efficient risk/return frontier would be the orange line in the chart above. Those investors that are highly conservative and choose to invest 100% in bonds, his or her historical return would be 7.5% with an annual volatility, one form of risk measurement, of 6.5%. Those that are more daring and can tolerate a higher level of risk may want to invest up to 100% of his/her portfolio in equities. By willing to accept a higher level of risk of 14.5%, the reward for this action is a higher return of almost 9%. Alternatively, those that invest 100% in alternative assets such as 50% in hedge funds, and 16.6% each in commodities, international real estates and private equity will enjoy an annual return of nearly 12% with more or less the same level of risk as an all bonds portfolio.
This may sound too good to be true but non-traditional investments can add this “smooth out” effects because they behave differently from stocks and bonds or they dance to a different tune if you like. In technical terms, their correlation to traditional markets for stocks and bonds is low. Prices for commodities, for example, may on occasion move in the opposite direction to stocks, gaining in value when stocks lose and vice versa. As a result, investments in commodities are likely to smooth out the aggregate returns generated by a portfolio. This is illustrated in Chart 3 below. Let’s suppose we would like an annual return of say 9% by investing in a traditional stocks and bonds portfolio, the annual level of risk that one has to accept is 15%. However, by diversifying 5% to 10% of your portfolio into commodities, the annual return may stay the same but the level of risk will decline from 15% to about 12%.
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That said, not everyone can invest in commodities. Traditionally, only hedge funds and big institutional investors have the clout to navigate through the commodities markets where prices can be volatile and in the past, many types of commodities have underperformed for several years at a stretch. In addition, commodity markets tend to be less transparent and more difficult to access than traditional financial markets. All these factors argue for a passively managed approach to investing in commodities. This is the thinking behind Finansa Asset Management (FAM)’s recently launched Global Commodities Fund, which provides access to the Rogers International Commodity Index (RICI). Since its launch in February 2007, the fund has gained an impressive return of 29%.
Global real estate investments may also help to diversify a portfolio. However, certain types of real estate may react sensitively to the business cycle, much as equities do. Others such as Real Estate Investment Trusts (REITs) that rely on steady income flow from rental income tend to be more influenced by interest rates, reacting to rate changes in a similar way to bonds. In spite of the on-going sub-prime problems in the US and Europe, as an asset class, real estate has done extremely well over the past 3 and 5 years compared to equities and bonds (Please see Chart 4 below)
Chart 4
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As real estate markets are driven mainly by local factors, it makes sense to invest in real estate globally with a view to smoothing performance. Although, not yet available in Thailand but a couple of global and regional real estate Foreign Investment Funds (FIFs) are in the pipe line for launch in 2008 pending SEC’s approval. Meanwhile, there are several local property funds that are listed on the Stock Exchange of Thailand (SET) but the main drawbacks for these funds are liquidity problems and they are not very well diversified.
Those investors that are more sophisticated and have a fairly good understanding about modern financial theories, hedge fund investments can also reduce portfolio risks, given that most hedge fund managers aim to achieve absolute, positive returns as opposed to performance that is measured relative to a market index. This is illustrated in Chart 5 below. As mentioned before, there are tens of thousands of hedge funds out there and most of them are not regulated, therefore, it is advisable that hedge funds are suitable to only sophisticated and well-heeled investors. Since this is a fairly big topic, I will cover hedge funds in more details in the next issue.
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The same is true of private equity (PE) funds, where managers take direct stakes in business enterprises. Like hedge funds, traditionally, only high net worth individuals (HNWIs) have access to private equity funds, where the minimum investment tend to be quite large, USD 1 million or more, and liquidity tend to be quite poor. This is because the main focus of most PE is on the early stages of a target company and full value creation can only be achieved over a long-term period.
Like hedge funds, there are truly exceptional PE fund managers out there but there are also many mediocre ones. The trick is in managers’ selection, as clearly illustrated in Chart 6 below. It’s interesting to note that over the 5 and 10 years period, PE fund managers that are ranked in the 1st quartile against their peers outperformed the industry’s average return by a significant margin. In fact over the 10 years period, the average return of PE funds barely beat that of the S&P 500 Index, implying that if you end up choosing a mediocre PE manager, you might as well not bother and stick with traditional equities.
Chart 6
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The upshot of all this is that a portfolio with some non-traditional assets is likely to deliver a less volatile ride than one invested just in equities and bonds. Although, there is not a single rule of thumb that would apply to everyone but typically, most research papers suggest that an efficient portfolio – one that delivers the maximum return for a given level of risk, should typically contain non-traditional assets worth up to one-quarter of its total value. This 25% allocation would comprise up to 15% in hedge funds and private equity investment, up to 10% in listed and direct real estate investments and up to 5% in commodities. The exact weighting towards non-traditional assets would depend on the individual investor’s aims and risk appetite.
Lastly, investors should be aware that non-traditional assets combine their attractions with specific risks and potential drawbacks. Hedge funds and private equity funds invest in unlisted companies, which usually bear higher risks than listed equities. Therefore, the full diversification benefits of non-traditional assets are only achieved when they are held over a complete business cycle, which is likely to extend over the best part of 10 years.