CONCRETE DETAIL
by Christopher Joye
Posted 7 Sep 2009 8:04 AM
Well, at least the Future Fund agrees…
Regular readers will know that we’ve been banging on about the seemingly flawed asset-allocation strategies that have resulted in over 50 per cent of all the default Australian super fund’s money being invested in Australian and international equities (according to the latest Rainmaker data). And that’s 50 per cent after the Australian share market had declined in value by 35 per cent following its November 2007 peak. Put differently, the default Australian super fund’s weight to local and international equities would have been north of 75 per cent prior to the crisis (assuming that they have not sought to boost their exposures in the period since the correction and taking as given the extremely high correlation between Australian and international shares).
And here is a scary thought for equities spruikers – it took well over six years for the Australian share market to simply recover its previous peak of around 2,305 points after the 1987 crash, which was notably smaller than the crash that has been experienced during the GFC (see chart). Even more disturbingly, it took an incredible nine years – until the end of 1996 – for the Aussie share market to consistently breach the 1987 peak.
Source: ASX; Rismark International
Anyway, it would appear that at least the boffins at the Future Fund agree with our arguments judging from their investment policies. With all the advice and resources in the world, the recently established Future Fund’s target portfolio weight to all listed equities is just 35 per cent (see below). Stunningly, the Future Fund’s allocation to “equities” also includes “private equity”, which as I have noted here many times before, is – notwithstanding the claims of private equity managers – also highly correlated with equities (ie, patently not a “diversifier”). Take a look at the horrific private equity returns during the GFC – the strong comovements with shares makes intuitive sense once you understand that private equity guys exit their investments by selling them into listed equity markets or via a trade-sale to a listed company.
Source: Future Fund
Investing half to two-thirds (or more) of all Australian workers’ hard-earned capital in listed equities is problematic for at least three reasons:
(1) Given the circa 60-70 per cent long-term historical correlation between Australian and international shares there is little-to-no diversification benefit investing in both (especially considering these correlations approach 100 per cent during crises when you are most in need of said diversification);
(2) The 16-17 per cent per annum annual volatility (or risk) associated with listed equities, which appears to be increasing not decreasing over time as global markets become more interconnected, makes the raw returns that equities deliver look quite unattractive on a “risk-adjusted” basis; and
(3) When one undertakes standard mean-variance portfolio optimisation analysis over the longest credible period (which we believe to be 1982 to 2009) the desired allocation to Australian equities that is outputted is less than 20 per cent (given a nominal return target of between 9-12 per cent) with no money – yes that’s zip, zero, nada, nothing – invested in international shares.
To avoid any confusion here, this portfolio optimisation exercise is akin to sitting at the start of 1982 with the option of investing in Australian shares, international shares, government bonds, bank bills, commercial property and residential property, and asking yourself the question: what would be the lowest possible (portfolio) risk combinations of these assets that yield me my target return – say 10 per cent per annum – if I knew exactly what was going to occur over the next 26 years (ie, through to June 2009). It is, therefore, a simple but nonetheless informative exercise for investors to undertake – ie, there is no guarantee that the last 30 years of data is going to be informative of the next three decades. But it is a useful start and far better than pure speculation.
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