We have seen numerous investment trends come and sometimes go over the last X number of years whether it be technology, commerical property, Buffettology, CDOs, high yield, hedge funds, mortgage funds, etc, but at the end of the day a balance of the key investment risks wins through….i.e. the risks relating to equity, liquidity, interest rates, credit, currency, and inflation.
These are my current thoughts on these risks and some investment themes…
- Liquidity Risk – forgotten for many years (particularly by the MTAA Super fund, and mortgage investors…remember Estate Mortgage???) but it still exists…forget chasing returns and having liquidity at the same time!!! Know what liquidity you need and hold CASH…not the so-called liquid Asian High Yield securities Basis Capital used for liquidity or even Enhanced Cash funds…CASH in a bank or pure Cash Management Trust that get’s it returns from 11am, government securities, and bank bills.
- Equity Risk…guess what? equity risk doesn’t just turn up in…equities! It can also be found in corporate bonds, hybrids, hedge funds, property securities, and many others…it is essential to understand the true equity risk a portfolio has and don’t push some of that risk into the more conservative asset classes like fixed interest. Equity risk can be scary, is required for growth, and shouldn’t substitute for anything else…like…an inflation hedge!…investing in equities is often a poor hedge to inflation as the 1970s showed…high inflation is not good for equity performance at all
- Interest Rate Risk…too many have ignored this one…but it can work in your favour in a crisis and can provide some portfolio stability…stockbrokers should try them some day…the whole “everything correlates to one in a crisis” is absolute rubbish…during the global financial crisis, those who diversified their portfolio with pure interest rate risk (i.e. little to no credit risk) from boring government bonds or conservative bond funds received double digit returns from this risk. During a crisis, investors run to quality and boring government bonds are just that…why don’t retail investors want to invest in quality???
- Credit risk…in times of crisis this is highly correlated with equty risk…as a result when building portfolios ensure your credit securities do not result in overweighting the exposure to equity risks. However, always keep in mind that credit securities have a negatively skewed return distribution…limited upside with massive downside…so why not just invest in equities instead and leave the fixed interest to boring governemnt bonds???
- Currency risks…what’s the Australian dollar going to do? Answer…absolutely no idea. So what to do? Being unhedged was favourable during the GFC as Yen carry trades returned to Japan and the flight to safety went to the US (yep….good ol’ Australian currency wasn’t considered that safe!). So perhaps unhedged is the go…however, the reverse was true in the recovery…market timing is very very difficult so if you don’t know, and I don’t, perhaps 50% hedged, and 50% unhedged is the go for global share allocations. Its difficult to invest in international bonds without being hedged to the Australian dollar…I guess if you want ot investin bonds for their safety and income then currency risk removes the safety aspect and perhapd hedged is best.
- Inflation risks…this is my favourite…bonds are best during deflation but the only investment that (hopefully) guarantees strong performance during high inflation is INFLATION LINKED BONDS!!! Governments around the world, including Australia, are issuing more…woohoo!…let’s get on board and reduce inflation risk from our portfolios. Life companies issue inflation linked annuities also…let’s look at them as well.
- Commodities can also can be a good inflation hedge also but they certainly carry a few other risks but are worthy considerations as they provide diversification with other asset classes. The only thing with commodities is…they mostly supply and demand driven!…there’s not really much added value there, so…good luck with picking supply and demand!!!
- Hedge Funds…these guys carry equity risk and/or credit risk…when markets crash…SO DO Hedge funds…the marketing myth of positive returns in any market has been exposed by the GFC and there’s two other things…its very very difficult to get your money out and their fees are so big that they have to take on significant risk to get the return…but at the end of the day if you don’t know how a fund invests you don’t know the risks so…don’t invest
in hedge funds! - Emerging Markets…all the rage because of their economic growth…guess what…there is no evidence that shows high returns from countries displaying high economic growth. If Emerging markets aren’t in a bubble today…they probably will be tomorrow…so proceed with caution.
- Mortgage funds…they’re gone for a long time
- Australian economy…had an amazing run and is the leading economy in the developed world but keep this in mind…we’re basically a hole in the ground and reliant upon commodities. If the emerging economies falter and decide to stop buying our commodities then look out Australia…things may not be so rosy…just keep it in mind…and stop being so complacent about the Australian economy…I know you are so stop it!
- Property…I think I need a new Post for this one! Stay tuned