The volatility all share markets have experienced at the start of 2016 is tipped to continue. Kris Walesby demonstrates how investors can prevent falling victim to these market conditions.
Volatility is a term frequently used to describe periods of financial market turbulence, but what does it really mean, how can it be managed and does designing your portfolio to protect against this mean sacrificing performance? With experts predicting a difficult 2016, investors should be seeking straightforward answers to these questions.
Markets are expected to experience increased volatility this year. At the moment, the United States Federal Reserve raising interest rates is, rightly, front and centre as the key issue facing economies and investors around the world. However, historically, although structural economic changes like a rate cycle turn will cause heightened volatility, it is normally the less expected shocks that derail the markets. Potential shocks may come from a number of quarters, such as the Chinese economic slowdown and where it could lead, or escalating tension in the Middle East.
In the same vein, heightened protectionist measures to avoid terrorist attacks or an influx of refugees could rapidly degrade the quality of world trade, pushing the global economy into another recession. It is not certain where the next shock will come from, nor whether it will be in 2016, however, there is general growing unease that things have been too good for too long. That lack of confidence in itself can sow the seeds of a more volatile period.
All of the above would certainly create increased volatility, but investors don’t necessarily need to fall victim to this. It is difficult to minimise the entire impact of such headwinds, but by diversifying and using simple asset allocation strategies, this can be mitigated and investors will be in a significantly stronger position to participate in the upside when volatility declines.
Simple rules to diversify your portfolio
Like volatility, diversification is used regularly as an answer to an investor’s prayers. The reality is if diversification is implemented correctly and combined with asset allocation, an investor will be in a position of strength relative to most others and will be using techniques favoured by professional fund managers. But what do the two concepts mean?
Diversification does work. The principle can be proved mathematically that an investor who holds around 30 or more stocks/bonds in a portfolio has spread risk enough that the chance of one individual component or sector having a significant effect on the portfolio is dramatically reduced.
Unfortunately, the reality is most Australian investors simply don’t manage their portfolios like this. Instead, there is a very concentrated focus on financial and resource stocks that pay regular dividends and are normally included because they are seen as ‘Australian fortress’ companies with little chance of significant price decline. This is not sensible portfolio management. Today we see the intense decline in the resource sector impacting on many Australians and the banks, which may be strong from a global perspective, are not immune either. Even if an investor were to invest just in Australia, it pays to take a broader perspective and make sure the portfolio has exposure to more than 30 stocks to reduce the impact of a downturn in one or two sectors.
However, even if investors do diversify within Australia, without investing in international equities and bonds they are heavily exposed to a market that makes up only 2 per cent of the global economy. A well-diversified portfolio therefore is not just one consisting of 30 or more Australian securities, but one where a single company, sector or country will never have enough impact to significantly affect the entire portfolio.
The other component needed to protect a portfolio from volatility is applying asset allocation. It can be shown the strongest performance driver of a portfolio over time is the percentage invested in each asset class versus the specific stocks or bonds within them. Many Australians do not consider this approach, partly because it can appear to be hard to achieve (buying bonds directly is expensive) and because Australia has an equity-focused culture by virtue of generous franking credits. If an investor believes there is volatility looming, it can pay several times over to increase exposure to asset classes that can perform better in turbulence, such as bonds and defensive equities.
Generally most Australian investors are doing neither of the above. Most have a highly concentrated portfolio of Australian equities, no bonds, potentially a property exposure, and a large percentage (30-plus) in cash. This is partly due to habit, but also because they are unsure how to achieve diversification and asset allocation simply and cheaply. For this reason exchange-traded funds (ETF) have risen in popularity in recent years and are expected to continue to do so as they provide an easy remedy to manage portfolios and to reduce volatility.
Consider costs and find smart ways to invest
ETFs are a type of fund that gives investors a cheap, robust and flexible mechanism to manage their portfolio. Although a relatively recent phenomenon in Australia, in the US, where the market has risen to a value of over A$2.5 trillion, investors have found them to be one of the most suitable product types to achieve diversification and asset allocation.
In most cases ETFs are not actively managed funds. Instead they seek to track an index. So if an investor wanted to buy an ETF on the ASX 100, they would buy an ETF that tracks that index so closely it mirrors all aspects of it – for example, if the ASX 100 moves up 1 per cent, so will the ETF.
The critical point is ETFs are not trying to outperform the market. They mirror exactly what the market is doing so the investor doesn’t need to focus on which active managers are most likely to outperform and can instead focus on how best to diversify their portfolio and in what ratios to allocate assets. As the ETF is not seeking to outperform, the fund cost is normally at least 50 per cent less than an active equivalent and often much more, so portfolio costs are automatically much lower with more chance of gaining a better return as the investor has now focused on key drivers, namely diversification and asset allocation.
ETFs trade like stocks and can be bought through any brokerage platform during trading hours. This is a key benefit, but the most important benefit, apart from the reduced cost, is probably the range of exposures available.
For example, to reduce a high degree of stock concentration (one of the primary causes of large negative portfolio performance in a typical Australian investor’s portfolio), investors can buy an ETF that tracks the top 100 companies in Australia. The fund does all the work for a very small fee and automatically gives the investor all the diversification required to dramatically reduce the portfolio’s risk with one trade.
Similarly, many Australian investors focus on domestic stocks due to the franking credits, which can help to grow the portfolio and pay a stream of cash for retirees. However, if the portfolio created to achieve this result is focused on just a few big names, a retiree could easily find their capital amount has reduced significantly because those particular stocks have underperformed.
An alternative is to use an ETF that tracks the highest-quality, yield-focused stocks for you. Again the respective fund gives immediate diversification, thus raising the probability of protection when markets become more volatile, while ensuring the best-yielding stocks are selected.
ETFs give easy exposure to overseas markets
Looking at the wider picture, one of the key reasons for increasing usage of ETFs is the easy exposure they provide to international markets. Many investors have watched the Australian dollar’s swift decline versus the US currency and they want access to the US market to take part in this.
Additionally, they understand the US is 50 per cent of the global market and so US exposure achieves a significant part of their geographic diversification. Again, with one trade, an investor can get full exposure to the US via an ETF that trades in Australia during our market hours. There is no need to select specific stocks and take all the inherent risks and administrative hassle in buying individual stocks. This is why ETFs work so well for Australian investors.
Furthermore, to achieve the second element in protecting the portfolio from volatility, namely asset allocation, there are ETFs providing access to Australian and international fixed income. Additionally, if investors believe commodities and foreign exchange can also offer protection (which they certainly can if used correctly), ETFs provide access to gold, for example, or a bet on the movement of the US currency versus the dollar without the need to invest in the US equity market to achieve it.
One question investors regularly ask is whether in buying ETFs they are sacrificing quality for reduced price. The fact is all ETFs in Australia are held to the very highest standards by the market regulator. This means every ETF issuer must meet some of the world’s most stringent tests to ensure their funds are the very best in quality and investor safety.
Make sure your portfolio is right for the times
In the final analysis, many believe that, in some form or another, 2016 could usher in an era of heightened volatility. Some of the forms this volatility will take are known, but the unknowns could be the most damaging and that is why it is critical to manage portfolios to mitigate such events. Many Australian portfolios are ill-designed to weather this, but by diversifying the number of securities as well as the region and theme, they can spread their risk.
Additionally, and of equal importance, is managing the asset allocation ratio, that is, if an investor thinks volatility is looming, then they should tilt the portfolio towards fixed income and cash versus equity. Also, consider commodities and fixed income as alternative classes that provide properties not available in equities or in cash. Many Australian portfolios are dangerously focused on equities and property with no consideration to other asset classes.
ETFs aren’t the complete answer to these issues, but are probably the most flexible, robust and cheap way for an investor to achieve many of these goals. They are easy to trade, cost-effective and the wide range of products allows an astute investor to adopt many of the skills of a professional fund manager to protect their portfolio from dramatic increases in volatility.