Given covid-19’s extreme shocks on the markets, clients have been increasingly finding that their ‘more cautious’ investments have not performed in line with their expectations and many are naturally asking why.
This is uncharted territory for many clients considering that multi-asset funds have seen positive returns for most of the past decade: with the ABI mixed investment 0-35% sector posting an annualised return of 5.0% (to 31/12/19) and slightly outperforming the previous ten years, which had an annualised return of 4.4%. Now, in this unprecedented world we find ourselves in, there has been much talk about what these market freefalls mean for returns moving forward. While this is an understandable concern, the main consideration in our view, especially when factoring in risk, is not the level of return per se but rather the level of downside risk that a fund exhibits.
For instance, over the past ten years, we have seen a notable rise in the level of maximum drawdown in the ABI Mixed Investment 0-35% sector compared to the previous ten-year period. See chart below. (This excludes the global financial crisis since it would skew the data.)
Max Drawdown over the last 24 years
(excluding the two dramatic years of 2008/09 where the drawdowns were unusually large)
Source: Morningstar. Annualised performance from 01/01/1996 to 31/12/2019 (excluding 2008-2009). Past Performance is not a guide to future max drawdown.
This certainly could cause worry for those clients who are in retirement or have a lower risk appetite since the increase in declines can substantially reduce the sustainability of their pots. With an ageing population and the fact that retirements are lasting longer, the need for investments aiming to minimise potential declines is only becoming greater.
While numerous factors can cause the increase in drawdown, the underlying asset allocation is what really matters. As such, when investing in sectors, the 0-35% is widely known to be cautious, the 20-60% balanced and the 40-85% adventurous. But, as many clients have come to realise, these names don’t always reflect the overall level of risk involved.
This has proved particularly true when we home in on market movements in fixed income over the past ten years and see that bonds, which are typically considered the lowest risk asset class (after cash), are not always as they seem. In this low for longer environment, we have seen more investors venture into riskier emerging market debt and high yield bonds in their hunt for higher returns. The point is that unlike investment grade credit, these higher risk bonds tend to correlate more with equities. So, when there are large pull-backs in the market, these types of bonds tend to reduce diversification and correlate with falling equities.
What lies beneath
The chart below neatly illustrates this explanation. The blue boxes highlight the potential returns investors have seen over the past 17 years in each asset class for 85% of the time (and based on monthly returns), while the red lines show the returns outside of the ‘norm’ or in other words during large market movements. As such, the red lines of emerging market debt and high yield look more like equities than they do fixed income. Thus, showing that clients who are invested more in emerging market debt and high yield subsequently increase their risk more than what their sector may suggest.
Expected and the unexpected
Source Morningstar. Performance 01/01/2003 to 29/02/2020. The blue highlights 85% range of monthly returns and the red highlights 100% range of monthly returns. Past Performance is not a guide to future performance. Currencies are local and not converted to sterling.
For clients, especially those with lower risk appetites and those in retirement, it is essential to look under the bonnet of funds that sit in traditional low risk sectors. At Canada Life Investments, we run a range of risk targeted, well-diversified and multi-asset portfolio funds that aim to take a more conservative approach to diversifying, preserving capital and generating long-term growth. These funds are designed to be aligned with your clients’ appetite for risk so that when markets turn, the ups and downs live up to their expectations.
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Past performance is not a guide to future performance. The value of investments may fall as well as rise and investors may not get back the amount invested. Income from investments may fluctuate. Currency fluctuations can also affect performance.
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