Better returns, lower risk

By Robin Bowerman, Vanguard

The two most important words in the investor lexicon are risk and return. In the run-up to 2008, eyes were firmly focused on the return side of the equation. The arrival of the global financial crisis later that year was a game changer and the pendulum representing investor sentiment has stayed firmly around the risk end of the spectrum.

This month we pass the four-year anniversary of the collapse of Lehmann Brothers, which to most pundits was the decisive event that fuelled what we all know now as the GFC.

It is an interesting time to reflect on where we are in the market cycle and, perhaps most importantly, what we have learned about risk.

With the end of 2012 in sight, the Australian sharemarket has returned a respectable 14 per cent for the past year, albeit the broad market index (S&P/ASX 300) five-year performance figure is -3.4 per cent.

Overall, many of Australia's leading companies by market capitalisation have done well by shareholders, particularly when dividends and franking credits are taken into account. But risk comes in many shades of grey and understanding the true risk within a portfolio is one of an investor's key tasks.

The return and risk factors

Let us take three different portfolios and look at how they compare on return and risk factors.

We chose 10 shares from the top 50 most-traded over the past three years (2009/2010/2011), all well-known Australian companies. We looked at the result of an investment of $500,000 over three years, invested equally (equally weighted) into these 10 shares and what the outcome would be by swapping just two of them with two other equally popular ones.

The example in Figure 1 shows the portfolio return over the three years and both the total risk and the active risk built into the portfolio in these scenarios.

Active risk is the measure of how different portfolio returns are from the total market return or relative benchmark index. A concentrated share portfolio may have high active risk, relative to the benchmark portfolio, depending on the number of assets held. High active risk might imply that portfolio returns will deviate from the benchmark (and has an equal chance of deviating positively or negatively).

Total risk refers to the overall volatility of a portfolio's returns, and all investments come with some degree of total risk.

Portfolio one below contains many of Australia's household corporate names, including all four major banks. The result of this portfolio is detailed below - total return of 7.4 per cent per annum and total risk of 15.5 per cent per annum: a respectable headline return result that most investors would probably be happy with.

But focusing just on headline returns and not considering the risks built into your portfolio can be a dangerous strategy.

Three broad types of risk

Consider portfolio two - with just two shares being changed. Two banks are replaced by the large Australian property and construction company Leighton Holdings and the national airline Qantas.

The headline return has plummeted from 7.4 per cent to 2.8 per cent while the portfolio's active risk measure has increased to 16.5 per cent.

In broad terms there are three types of risk every investor confronts:

• Security risk - that the share you invest in underperforms
• Manager risk - that if you invest through a professional fund manager they will underperform
• Market risk - that the whole market does poorly.

What is illustrated by the difference between portfolio one and portfolio two is specific security risk, and that is a risk many Australian share investors carry where their portfolio is limited to a concentrated amount of direct shares.

Figure 1

Portfolio 1		Portfolio 2
$500,000 invested equally across 10 blue-chip Australian companies listed on the sharemarket in June 2009.		$500,000 invested equally across 10 blue-chip companies listed on the sharemarket - exchanging investments in Westpac (WBC) and ANZ and replacing them with Leighton Holdings (LEI) and Qantas (QAN) in June 2009.
BHP CBA NAB WBC ANZ TLS QBE RIO WES WPL	As at 30 June 2012 The portfolio value is $619,210 which is a return of 7.4% per annum The total risk in the portfolio is 15.5% p.a The active risk in the portfolio is 3.8% p.a	BHP CBA NAB LEI QAN TLS QBE RIO WES WPL	As at 30 June 2012 The portfolio value is $542,830, which is a return of 2.8% p.a. The total risk in the portfolio is 16.5% p.a. The active risk in the portfolio is 4.3% p.a.

Source: Standard & Poor's, calculations by Vanguard. This information is provided as an illustration only and is not investment advice. We have not taken anyone's circumstances into account in providing this information.

There is a considerable amount of discussion around the risk of the Australian sharemarket being concentrated in two sectors, banking and mining.

Diversification is the key tool at every investor's disposal to lower their risk, either to specific shares or specific sectors.

By increasing diversification you can lower this risk, but how that is executed is important because buying lots more individual shares may make your broker happy but comes at an unrealistic cost to the investor.

The growing use of ETFs

This is where the efficiency of exchange-traded funds (ETFs) can come into play. The adoption of ETFs is growing in the Australian market along with the range and types of these funds available.

Australian investors now have about $4.2 billion invested in ETFs, and early adopters are saying that the low cost and diversification they offer are the key reasons for using them in their portfolio.

ETFs are managed funds that are quoted for trading on a sharemarket just like an individual share and therefore offer the real-time trading ability that existing sharemarket investors are familiar with.

Australian equity (or share) ETFs also provide the same opportunity for income generation through dividends, which you can generally choose to reinvest or realise, and franking credits from the companies included in the underlying index also pass through to the individual investors.

More recently, share ETFs have been joined by ETFs tracking fixed-income indices, which adds another valuable level to the diversification argument.

If you compare the two sample portfolios above with the same $500,000 invested completely in the Vanguard Australian Shares ETF (see below) over the same period as above - three years from 30 June 2009 (see Figure 2) - you will see that portfolio one delivered both a higher return and higher total risk, while portfolio two (with just two shares different) delivered markedly lower returns and higher risk.

These scenarios represent two ends of the diversification spectrum - concentrated 10-share portfolio versus the broad market index of 300 companies.

But it does not need to be an either/or argument. By all means invest in the companies you are strongly confident will outperform over the longer term. But by adding one broad-based ETF you can significantly lower the amount of active risk you are taking.

Another way of thinking about this is as a core-satellite approach to building a portfolio: lock in the market return in the core of the portfolio and add in satellite positions where you have strong conviction that there is a good chance of outperformance.

Figure 2 - Portfolio 3

Portfolio 3
$500,000 invested in Vanguard's Australian Shares Index ETF (VAS) giving exposure to the 300 largest companies listed on the Australian sharemarket.
	As at 30 June 2012 The portfolio value is $588,170 which is a return of 5.5% per annum. The total risk in the portfolio is 14% p.a The active risk in the portfolio is 0% p.a

Source: Vanguard. Returns of the Vanguard Australian Shares Index ETF

The right combination for your portfolio is something only you and/or your broker/adviser can know, but the graph below at Figure 3 examines combinations of what the risk and return of a portfolio that combines an ETF investment with the direct share portfolios one and two described above.

When VAS is included in the portfolio, both total risk and active risk fall, showing the diversification benefits of shifting an allocation in portfolio one or two towards the market portfolio VAS.

Figure 3 - Three year period ending 30 June 2012

Source: Standard and Poors, calculated by Vanguard. This information is provided as an illustration and is not investment advice. Total return, total risk and active risk calculations are applicable to the three year period ending 30 June 2012.

In reality, many individual share portfolios are significantly under-diversified, and this can increase both costs and active risk within a portfolio. Prevailing market volatility and the impact of positive and negative news on a daily basis can drive many investors to trade in and out of particular shares frequently, often at the wrong time.

By diversifying your portfolio adequately in a cost-efficient manner, investors can hopefully control risk while still seeking returns that will achieve their long-term investment goals.

About the author

Robin Bowerman is Principal, Market Strategy and Communications, at Vanguard Australia.

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