The world is a dynamic place and financial markets seem to be even more dynamic than ever. While predicting the future is fraught with danger, there are certain investment practices used by professionals that are tried and true. By adhering to these, investment professionals aim to maximise returns and minimise the risk of a negative return in the longer term, despite being unable to guarantee investment returns.
Investing, while not a formal science, is based on fundamental principles, and the main one is to have an appropriate long-term investment strategy and to stick to it. Determining a super fund’s strategy requires much time and attention. Once the strategy is set, it makes little sense to make decisions that may compromise its success over the longer term.
A common example of this is a desire to increase the cash allocation above the strategic asset allocation when the share market appears to be weak. Based on investment principles, this is exactly the wrong time to do so. Weak markets are a good time to buy at prices cheaper than before. This should be productive over the medium to longer term, although it will not be a good thing if markets stay weak. But investment time frames in super are generally long, and overall this is a sound and sensible strategy.
Another common example is the view that interest rates “are likely to rise” and so “why are super funds investing into fixed interest assets such as bonds?” The simple answer is that the strategy should be designed to meet the fund’s objectives over the long-term, and that the asset allocation to bonds (based on the investment strategy) is there as part of that goal. Bonds, like any other asset class in the super fund, play a particular role in a diversified portfolio. Trying to second-guess what the bond or share market may or may not do is difficult, even for professional fund managers.
But what if super funds get it wrong? What if money is allocated to cash and the markets rally? What if money is held back from bonds and interest rates stay the same or fall further? What if investors believe that equity markets are “overvalued” and they keep going up? Any decision made by investors to move away from their strategy needs to be carefully assessed to determine how it may affect the likelihood of achieving the investment objective. Investors may get it right some of the time, but the chances of this occurring on a consistent basis are remote and the cost of getting it wrong can be high.
One of the most common questions asked of investment professionals relates to investment in “risky” assets. For example, how can it be possible to invest in risky sectors like private equity, emerging markets and opportunistic property without the super fund taking on too much risk? The answer is simple — it’s the overall investment strategy that matters. Within a well-diversified portfolio, it is possible to invest in an asset class that, in its own right, is relatively risky without compromising the risk of the overall portfolio. From a risk perspective, individual assets should be considered in the context of their relationship to the overall portfolio, and are risky only to the extent that they add risk to the overall portfolio.
Unfortunately, past performance does not provide a foolproof guide to future returns (while hindsight does). The best way to show this is through performance surveys. Good managers go through periods of bad performance that may have nothing to do with their ability to manage money. If they do suffer from poor short-term performance, investors need to ask and understand why. If the manager’s style is out of favour, but it is reasonable to expect that the manager’s performance can still be met going forward, then it might be worth hanging in there.
There is no such thing as a free lunch. In investment markets, some investors assume that they will get a high return without taking high risk. The easiest solution is to think about this in terms of a straight-line trade off. That is, to get high returns from an individual investment, the investor invariably needs to take high risk. A super fund that is too conservative (and the impact of inflation, tax and costs are applied) over the longer-term runs the real risk of delivering inadequate returns to members.
Remember that risk is not an enemy for investors. In fact, it is a very important flipside to the return coin, and the good news is it can be more effectively managed than can returns in a super fund. So what do super funds do about managing risk? First, they understand all the potential risks in the fund by identifying them. Then they ascertain the worst-case scenario. If one seemingly low risk active position has some probability of wiping out all of the other good work in the fund, then this needs to be understood in advance. Super funds should aim to take intended risk only — unintended risks are often shocks, not pleasant surprises!
— Lisa Fazio is the investments and governance manager at HESTA.
