Investment Strategy

Three essential strategies to reduce risk in a portfolio

By Matthew Hopkins
Sydney, Australia

The timing of a market shock will dramatically alter investment returns and the length of time retirees’ capital lasts. Advisers with clients nearing, or in, retirement, at the point of maximum wealth, should take steps to preserve capital and protect against sequencing risk.

Reducing risk and sheltering a portfolio from a significant decline, similar to that experienced during the GFC, could make a huge difference to its value and could make the difference between a happy and a miserable retirement.

If clients want reduced volatility, protection against severe market falls, smoother returns and to grow wealth over the long term, there are three essential strategies advisers should use.

1. Use Dynamic Asset Allocation

Asset allocation is the process by which a portfolio’s capital is diversified across different asset classes, for example equities, fixed income and property. The asset allocation decision is vital in determining whether or not investment objectives are met.

There are two broad methods of asset allocation, each based on different timeframes. Strategic asset allocation is based on a long-term horizon and the expectation of asset class performance is set. Therefore the allocations between asset classes will not move much over time.

Dynamic asset allocation (DAA) is based on a shorter timeframe and requires active decision making and portfolio manager skill to reallocate between asset classes depending on where the portfolio manager sees opportunity.

Dynamic asset allocation (DAA)

  • Based on a shorter time horizon
  • Influenced by market cycles
  • Can reduce portfolio risk
  • Suits investors who cannot afford a sharp decline in wealth, but want to steadily grow capital, eg retirees

Strategic asset allocation (SAA)

  • Assumes long-term return horizons of five years or more
  • Ignores market cycles
  • Often applied by traditional diversified funds
  • Suits investors in the accumulation phase who have time to withstand market fluctuations

The benefit of DAA is that it offers greater opportunity to increase exposure to attractive assets and avoid or sell unattractive assets. As well as benefitting from rising assets, there is also greater scope to reduce risk in portfolios as the portfolio manager can apply a ‘flight to safety’ strategy and, for example, reduce exposure to higher risk assets such as equities and increase exposure to cash or lower risk assets such as fixed income.

DAA is most effective when it can be applied to a portfolio that is not tied to a benchmark or peer group, as the portfolio manager has greater flexibility to reallocate capital between asset classes. It can be used as part of a strategy for clients who want to steadily grow their capital. For those with a high exposure to sequencing risk, for example near the date of retirement, DAA can prove beneficial especially when combined with the other two essential risk reduction strategies.

2. Find Diversified Sources of Return

Diversification works at various levels, for example owning more than one stock and more than one type of asset, in different industries and different countries. Better diversity can reduce the possibility of poor outcomes in unexpected economic environments.

Typically an SAA strategy tends to have a large exposure to Australian and global equities. Clients are therefore relying heavily on the performance of two groups of equities for performance. Greater diversity will come from reducing the exposure to Australian and global equities and increasing exposure to a broader range of assets, but also from using a range of diversified strategies that can provide additional return streams to collectively produce returns steadily over time.

Some examples of different strategies are:

Inflation-linked strategy

If inflation spikes higher, this can be particularly damaging for retirees as the value of their savings can be depleted faster, which may ultimately result in them being unable to fund their retirement. An inflation-linked strategy is designed to produce returns that are in part tied to inflation, and therefore have a built in adjustment if inflation rises, helping to protect retirees’ spending power. Inflation linked bonds and to some extent, listed infrastructure and listed property, provide this benefit (an infrastructure asset, such as a toll road, is able to increase its fees with inflation (or more) each year; likewise commercial properties can usually increase their rents each year).

Equity investment strategies

Most equity investment strategies are ‘long only’ and will benefit if their underlying assets rise. But other strategies are ‘long/ short’, and can potentially benefit not only when equities rise, but also when equities fall (called ‘shorting’). For example, an investor can buy shares in company ABC if they expect the shares to rise, but they can also place a trade that will benefit if shares in company XYZ fall. Protecting, or even benefiting, from falling prices provides greater opportunity and can reduce portfolio risk.

Absolute return strategies

These are designed to deliver positive returns regardless of market direction. There is a wide range of strategies that are used by investors within this broad group. A particularly effective method is the use of managed futures that are designed to provide positive returns in both rising and falling markets. These strategies tend to make money when there are strong trends in either direction and they also tend to provide maximum diversification when markets are falling, which can help those in or around the date of retirement who cannot afford to experience a sharp decline in their wealth.

Employing diverse strategies, as well as investing in a variety of different asset classes, can produce outcomes that are driven less by share market direction and more by different types of risks. This extra layer of diversification can help produce a consistent stream of returns and assists in providing clients with the highest chance of achieving their objective with the least risk of loss.

3. Take Out 'Insurance'

As we have seen, extreme, unanticipated market falls can be devastating for clients approaching or in retirement. In some cases they simply won’t have time to recover. Dynamic asset allocation and diverse strategies can reduce risk in a portfolio under ‘normal’ market conditions, but another method is needed to soften the blow of extreme market falls – tail hedging.

Tail hedging is the process of identifying and purchasing investment assets and securities that could rise in value when other assets in the portfolio are temporarily making losses.

A tail hedging strategy is not designed to protect against all market falls, but it could limit the losses from significant market falls. By putting tail hedging in place, akin to insurance, advisers can potentially protect their clients from bearing the full brunt of portfolio loss.

The AMP Capital Multi-Asset Fund helps protect clients’ wealth against severe market falls and seeks to grow wealth over the long term. Click here for more information.
 

  • Diversification
  • Goals-Based Investing Update
  • Investment Strategy
  • Risk Management

Important notes

While every care has been taken in the preparation of this article, AMP Capital Investors Limited (ABN 59 001 777 591, AFSL 232497) and AMP Capital Funds Management Limited (ABN 15 159 557 721, AFSL 426455)  (AMP Capital) makes no representations or warranties as to the accuracy or completeness of any statement in it including, without limitation, any forecasts. Past performance is not a reliable indicator of future performance. This article has been prepared for the purpose of providing general information, without taking account of any particular investor’s objectives, financial situation or needs. An investor should, before making any investment decisions, consider the appropriateness of the information in this article, and seek professional advice, having regard to the investor’s objectives, financial situation and needs. This article is solely for the use of the party to whom it is provided and must not be provided to any other person or entity without the express written consent of AMP Capital.

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