Where can you earn the highest risk adjusted returns

Pitchbook’s (a Morningstar Company) Quantitative Perspective Report Q4 2023 details the shift in the risk and return profile of asset classes since 2021.

It leans on research conducted in the US by Horizon Actuarial. Each year, they survey 42 investment firms that share their capital market assumptions - the expected returns for various asset classes. The result of the survey is an aggregated view of these assumptions that can give investors insights into how to manage risk in their portfolios.

The report outlines the circumstances for the change in the efficient frontier, the optimal allocation to maximise returns given the risk taken. If you are below this theoretical frontier, it means that you aren’t being properly compensated for the risk that you are taking on in your portfolio.

The efficient frontier is a professional term and theoretical concept that is not something usually considered by individual investors. However, the concept may provide some insights into how we should think about risk and return. Additionally, as the efficient frontier is used by professional investors it governs the decisions that many asset managers make when positioning their portfolios. The efficient frontier informs the moves of these institutional investors that galumph around the market. Even if individual investors have no interest in asset classes that may be the current flavour of the month, such as bonds, it will impact returns.

For most of the decade following 2010, expected long-term returns across asset classes were low. We entered the era of ‘TINA’ – There Is No Alternative. Cash and bond returns were dismal. Many investors saw no point of investing in any other asset class than equities. Monetary stimulus and risk premiums bottomed out in 2021 and many investors started searching for riskier assets due to low return expectations. This was a time where private equity and small-cap equity strategies saw inflows.

The long-term outlook for returns now looks quite different than it did over the last decade. The efficient frontier has shifted higher, but this shift has not been uniform. Less risky assets like cash and bonds have become more attractive which allows investors to take on less risk to meet the return targets for their portfolios. In turn, there’s been less demand for riskier assets like small cap shares and private equity.

The shift of the efficient frontier has changed how much risk investors need to take given a consistent return target. The report illustrates this point by creating two optimal portfolios assuming a typical 7% nominal return target using expected returns from 2021 and 2023. For this portfolio, private equity was capped at 40% to reflect a reasonable liquidity risk profile.

What we see in 2021 is that the optimal allocation to core bonds was 0%. The rest of the portfolio was allocated to ‘risky’ assets across equity, credit, and real estate. As investors, a lot of us would not have portfolios that looked anything like that ‘optimal’ portfolio. It is illustrative of how difficult it was for investors to achieve a 7% return at that time.

What we see now, two years later, is that the rise in bond yields has resulted in an increase of the optimal allocation to core bonds to 45%. This is pulling allocation away from those riskier assets like private equity.

Minimising risk to maximise return – the optimal levels Source: Pitchbook Quantitative Perspective report Q4 2023

The risk premium

The risk premium is an academic concept. It is useful to understand and add context to your own investment decision making. As investors, we exchange risk for returns. The risk, in this instance, is volatility – how much an investment bounces around.

The more volatile the investment, the more return that an investor should expect. Shares change in price more than cash but will have higher returns over the long-term. However, the volatility that is experienced while holding the security is also a function of the risk of permanently losing your investment. There is a chance that a company you own can go out of business.

US Treasury Bonds are considered risk free because there is no risk that investors will not receive their funds back. This is because a government that issues these bonds in their own currency also controls the printing of money. Need to pay a loan and don’t have the cash? Print it.

When you start taking on risk, the expected return trade-off should be considered. Unlike government bonds, a corporate bond carries default risk. Even if an investor invests in the safest company in the world, there is still a risk that the funds will not be returned to them – companies cannot issue currency like a government. The difference between a government bond and a corporate bond represents the additional return from taking on the risk that a company may not pay the investor back.

Shares have higher expected returns. Investors take on more risk with the expectation that they will be compensated for the risk. The higher return expectation is called the equity risk premium. The equity risk premium represents the return that is earned on top of the risk-free rate. This is not an abstract number – it is the price that investors are receiving for the risk that they take on.

Are investors being properly compensated for their equity investments?

The price of risk is important. It is easy to go back and look at the historic equity risk premium, but that isn’t necessarily going to reflect the risk that you’re taking on at any given moment.

The value of a share is the future cash flows that are generated by the company.

Higher valuation levels typically mean lower dividend yields. Lower dividends mean lower future returns as dividends traditionally make up a healthy portion of returns. In other words, a lower equity risk premium. Investors are not being compensated as much with future expected returns given the level of risk taken on.

Despite our natural tendency to fall victim to recency bias a rising market decreases expected future returns. A rising market becomes riskier when share prices have gone up - not less risky.

Source: Morningstar's Market Centre. Data at 14 February 2023.

Currently, we see the Australian market as overvalued. Does this mean that investors should shift their allocation to asset classes with higher risk premiums, such as bonds?

Investors often grapple with the push and pull between strategic and tactical asset allocation. Our asset allocation decisions are based on balancing asset classes depending on their risk and return profile to reach the rate of return required for our financial goals. This is strategic asset allocation.

Strategic asset allocation is your long-term asset allocation target. That is the process of defining your goal, calculating your required rate of return, and then figuring out how to allocate assets to get that return. This process may lead an investor to decide on an allocation of 90% growth assets and 10% cash to achieve a goal.

Part of the 10% in defensive assets would include core bonds. Meanwhile a tactical asset allocation may be a short-term deviation from this strategic asset allocation that is made based on market conditions. This would be increasing exposure to core bonds because of a belief that they are offering an attractive risk premium currently.

Making a tactical asset allocation decision should not be done lightly because regardless of the rationale, this is market timing. However, investors can take advantage of undervalued or attractive opportunities given specific circumstances – if they have liquidity, if they are not deviating too far from their strategic asset allocation and if they have the time horizon required for the investments that they are investing in.

In many cases a tactical allocation decision involves cash. An average investor is probably not going to move 2% of their portfolio from listed property to infrastructure because they see some anomaly in the relative positioning of those two asset classes. Similarly, an Australian investor’s bond exposure is not likely to be invested by individual bonds, and they likely don’t have the ability to pick and choose between weighting to particular bond exposures. It is more likely somebody might invest extra cash in shares or broad-based ETFs if they see an opportunity or build up a bit of cash if they don’t see opportunities.

As an investor, this is an underrated aspect of cash. Having some cash in your portfolio allows you to take advantage of opportunities. Just like having an emergency fund ensures you don’t have to sell shares when it doesn’t make sense. Having some cash in your portfolio means that you can buy shares when they are on sale. This is an investing lesson within itself.