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Reimagining risk trumps special skill

In part, it’s classic financial modelling for a dynamic asset allocation (DAA) strategy. But, Gosling is cautious employing the DAA terminology, because it means different things to different people. She agrees, however, it employs the same principles: moving allocations as the riskiness of assets also moves. Where it differs to some DAA connotations is that her team doesn’t move their strategies based on their perceived skill, but on the possibility of these scenarios eventuating.

Either way, forget static asset allocation. Gosling says the current economic environment and the high price of assets don’t leave much room for the traditionally

Gosling and her team of five asset allocation specialists quantify risk in terms of how much their funds and end investors could lose if any

one of 55 possible economic scenarios occurs. Funds are then stress tested under those scenarios and their asset allocation is modelled around it. It’s a point of differentiation, says Gosling, as most other fund managers, consultants or in-house investment teams might consider 10 scenarios at most, while others won’t consider them at all.

“We take the view we have to be positioned within our fund asset allocations for all scenarios, and for exogenous events,” says Gosling. It’s imperative to really understanding risk, she adds, “because we’re all grounded in our experience and it’s really hard to imagine a scenario that’s radically different to what we’re seeing now. But that’s what we have to do.”

Static asset allocation is a thing of the past says Susan Gosling, MLC’s head of investments, as funds face what she calls the toughest environment experienced in her 27 years of investing. KATE HAGE reports.

EVERY POSSIBLE SCENARIO

This isn’t about us forecasting the future, it’s about working out what could go

wrong and protecting against it… It’s less glamorous than working on the assumption a manager can predict

what’ll happen next – if that’s what a strategy is based on, it’s on shaky ground

www.investmentmagazine.com.au July 2014 investment magazine 11

Chant West statistics for MLCReturns to June 2013 (% pa) Horizon 4 balanced portfolio

1 year 15.1

3 years 8.3

5 years 4.1

10 years 6.9

CHIEF INVESTMENT OFFICER

strict approach, and flexibility will be critical in managing portfolios against a volatile backdrop.

“The really rigid strategic asset allocation, with no active overlay, is a thing of the past… That was borne out of the 80’s and 90’s when you didn’t really need to do anything because it came off the disastrous period of the 1970’s when prices were so cheap and so much bad news was already factored in. It was a low starting point – almost anything you invested in gave you a great return.”

Flexibility evolutionGosling concedes that moving away

from ‘static asset allocation’ won’t be easy or sudden. It is, after all, incumbent

on super funds and fund managers to stay true to label and some investors, whether wholesale or retail, like their asset allocations predictable and constant. Instead, Gosling believes, it will take a new generation of no fixed asset allocation funds to enter the market and be sold as such. In turn, the industry needs to move on from peer relative performance and benchmarking, and the final step is investor communications that help to better educate people about portfolio strategies, she says.

“All traditional, diversified fund managers have been stuck watching each other and now we’re in an environment of breaking away from that, through active overlays… The next phase requires a whole new generation of funds to be started and sold in

MLC have three flexible asset allocation funds, known as the ‘Inflation Plus Series’. The MLC Inflation Plus Assertive fund was created in 2005 pre the global financial crisis (GFC) and gained little traction in the years leading up to that, at a time when ‘alpha’ was on the tips of everyone’s lips and double digit growth among peers was common. Gosling says the fund was so flexible it was “almost a hedge fund” in the way it switched from a portfolio that was 70 per cent geared at inception to nil gearing two years later in 2007 as their perception of a high risk scenario eventuating grew. Nonetheless, and despite dreaming up a scenario of a GFC-like event pre-2007, the fund still provided a negative outcome for investors, losing 23.8 per cent over 2008. Comparatively, the average median balanced fund lost about 19.7 per cent in 2008.

Later, and as risk became a much bigger part of people’s conversations, Gosling says the fund gained popularity. It currently has approximately $1.1 billion in funds under management, which along with the theory of a switch away of static asset allocations, has provided grounds for Gosling and the product team at MLC to view it as a strategy with legs. In January last year they launched a further two ‘inflation plus’ funds.

“This next generation of funds are about achieving absolute outcomes, not relative to a benchmark or peers – you can beat the benchmark by 20 per cent and still be down by – 10 per cent,” says Gosling.

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a different way. [It requires] not talking about growth versus defensive, or the debt versus equity mix.

In this push for a more informed conversation about risk and asset allocations with end investors, Gosling and her team have gone one step closer through pushing for scenarios to be included in quarterly client communications. It allows them, she says, to better understand why they have positioned their portfolios the way they have, and why they don’t always outperform over the shorter term.

A 1970’s revival…

Gosling is an economist by training and it shows. She illustrates risk by fluently traversing a range of possible economic scenarios, from “Japanification”, 1970’s style inflation, to global conflicts and catastrophes. Asset allocation is not, a strict science. It begs for greater creativity than that, she says.

A revisit to the 1970’s decade of stagflation is Gosling and her team’s worst case scenario. She concedes however that high inflation scenario isn’t overly popular and is seen as an ‘outlier’ risk by most. Nonetheless it’s something her team “increasingly worry about” and more to the point, it’s her job to consider risk that way, she says.

“It was hard to pick what to do in the 1970’s, you had over-loosening of monetary and fiscal policy and cash rates were far too low. It sounds like an outlier, to see this scenario again, but we have to use our

imaginations.”So what does this scenario look like?

Gosling recalls the period’s commodity price spikes, a high US Dollar, bond yields climbing, high unemployment and equities flat lining, as the Dow Jones realised just 5 per cent growth over the decade.

“Asset prices have climbed higher on a very benign environment not supportive of it. As asset prices get riskier, we have to take risk off the table,” she says.

Taking risk off the table has seen Gosling

and her team aggressively dialling down the gearing of their MLC inflation plus assertive fund from 18 per cent two years ago to zero today, with a 5 per cent cash allocation so they can be opportunistic if and when volatility drives down asset prices. She says they use the same thinking and insights for the strategies of their traditional funds, but have less leverage to employ it due to the challenges of staying ‘true to label.’

So back to the ’70’s revival, and Gosling says there are some early signs that are cause for concern. Confusing jobs and wages data out of the US is one, she says, together with mistrust over the US Federal Reserve’s take on it all, faced as they are with an enormous debt bill from quantitative easing which would benefit from some inflation.

“There’s some signs in the economic data we’re seeing now that suggests a less extreme case of that could unfold. We’re seeing wages rise at the same time as high unemployment, they shouldn’t rise at the same time… Some say the Fed is in denial about that, some say they’re lying. Why? Because they have a debt overhang and have to get out of it somehow. If they get a bit of inflation that’s probably the ideal scenario. But if they say that bond, yields will jump and choke the affect of that inflation off.

“We as investors need to think about that. If they allow inflation to creep in, there’s a risk it’ll go too high, higher than they’d [The Fed] like

and you can’t measure these things… When you’re in an environment when inflation is spiking, it’s really hard to even know what it is at the time.”

As a final thought, Gosling talks about a step-change in the industry; of wanting to break down ‘behavioural propensities’ of following the crowd, chasing yield for fear of being left behind and of focussing on positions in performance surveys as a measure of success.

“It’s that nexus of behaviours we have to break to get much greater returns… Our tailored scenarios have changed dramatically, we’re evolving and switching a lot. It’s interesting and challenging work to be doing – it’s very dynamic asset allocation.”

What we see now is a very difficult environment – it’s the most challenging I’ve seen in the 27 years I’ve been investing. When cash is mispriced, virtually everything is mispriced, it filters through... It’s analogous to the pre 2008 environment

SUSAN GOSLING MLC’S HEAD OF INVESTMENTS