Past banking crises tell us that for a decent recovery to take place, bad debts must be removed from the balance sheets of banks. The US bank plan is not risk-free, but US authorities seem to be pulling out all the stops to make it work.
The global financial crisis (GFC) highlighted that quantitative measures of the riskiness of assets and the correlations between them are highly unstable.
There is a role for alternative and more exotic investments, but their diversifi cation benefi ts should not be exaggerated. Quantitative estimates of risk and diversifi cation need to be combined with qualitative assessments and there is no real substitute for government bonds as a defensive asset class.
The events of the past 18 months provide many lessons for investors*. Many of these relate to risk management and the way investment portfolios are created.
Risk control - from the old to the new and back again
Risk is a rather esoteric concept that has different meanings. It may be seen as the risk of a capital loss, or the volatility of an investment, or the risk a portfolio won't generate enough returns for a comfortable retirement. There is no simple definition but most tend to focus on the volatility of an asset as the best guide to risk.
Traditionally a key approach to managing the risk of an investor's portfolio was to combine a mix of 'defensive assets' where the bulk of the return comes from income (namely cash and government bonds) with 'growth assets', which have potentially higher returns from rising capital values but also more volatility - mainly equities and property. This approach saw investment funds categorised according to their mix of defensive and growth assets. For example, superannuation funds with a mix of 40% defensive assets and 60% growth assets are aimed at investors with a longer time horizon, whereas funds with a mix of 75% defensive assets and 25% growth assets are aimed at investors who may be closer to or in retirement.
However, for a variety of reasons this approach was called into question, giving way to a more sophisticated approach. This approach was less constrained by the growth/defensive pigeonholing of assets but rather risk control coming via a more diversifi ed mix of assets.
Several factors drove this
A search for higher investment yields as cash and bond yields were lower than 1970s and 1980s levels.
The realisation that the growth/defensive categorisation has become increasingly blurred. For example property investments have some bond-like characteristics and fixed interest now includes private sector debt which was more related to equities.
The bursting of the IT bubble in 2000 encouraged investors to follow the lead of endowment funds, such as those at Harvard and Yale, to invest in a wider range of risky assets than just equities and property.
Computing power and the growth of sophisticated quantitative techniques for measuring risk allowed and encouraged more sophisticated risk controls than just the pigeonholing of assets into defensive and growth.
The result was a range of developments, some of which are outlined below.
Real estate investment trusts or REITs became used as a partial replacement for government bonds on the grounds they will provide a higher yield based return than bonds but with just a bit more risk.
The use of funds of hedge funds as a replacement for government bonds on the grounds they will provide a cash or bond plus return with low correlation to equities.
Private sector debt in fixed interest portfolios.
Increased exposure to more exotic investments such as various credit based investments (CDOs and CLOs), emerging market equities and debt, private equity, commodities and infrastructure on the grounds they would provide more diversification.
Read the full Investment Insight.
* These were discussed in more detail in "Lessons learned from the global financial crisis," Investment Insights, December 2008.