Balancing portfolio risk against returns

When looking to protect a portfolio against the risks of inflation and recession, Kieran believes it’s important to understand — or form a view of — what the pathway through both inflation and recession is, and the timing of that.

From a multi-asset perspective, Centric Wealth approaches portfolio protection from a top-down approach, where its first consideration as part of the asset allocation process is strategic asset allocation. This becomes Centric’s anchor within the context of a market cycle.

“And then we look to make tactical decisions, which we typically consider on a quarterly basis, or when required as dictated by the market,” says Kieran. “Tactical asset allocation then allows for movement away from the strategic anchor to position portfolios for the near-term expected conditions, like reducing the weight to risk assets ahead of an expected slowdown. So, if you believe you are going into a recessionary environment, you’re going to drop some of your growth assets.”

The other ‘tools’ Centric relies on to protect portfolios against market risk is portfolio construction. This includes: asset class structuring; underlying investment choice; blending sectors and managers; and focusing on liquidity — while guarding against style drift.

Some of the strategies used at Centric Wealth to protect portfolios from the risks of inflation and/or recession include:

Inflation protection — Protecting against inflation that is higher than market expectations.

1. Treasury Indexed Bonds: If inflation is higher than currently priced, Treasury Indexed Bonds will outperform. However, if inflation is lower than expected, regular bonds will outperform.

2. Cash: Nominal returns should keep up with inflation, if accompanied by rising short-term rates. This was the best performing asset in Australia during 2022.

3. Equities: These need to be quality companies that can easily pass on higher costs and price increases to their customers.

4. REITs and infrastructure: In an environment with rising wages, higher rents can be passed on. Many infrastructure assets have inflation-linked revenue models. “We shifted our allocation between property and infrastructure to be overweight infrastructure during 2022 and 2023. On a relative basis, this outperformed,” says Kieran.

Recession protection — Strategies vary depending on the severity of the recession, the time of the recession, and the fiscal and monetary response to the recession.

• 1. Look for defensive assets: These include utilities, staples, and healthcare. Avoid overvalued companies relative to fundamentals, and always look for quality companies.
• 2. REITs with defensive characteristics: An example is Alceon, which holds properties with long leases to Government agencies.
• 3. Move up the capital stack: Reduce your exposure to equities and increase your allocation to fixed income and credit. “If more protection is needed, move from credit to Government bonds. In a recessionary environment, seek high quality credit. Go long-duration once rates come off or the monetary policy is clear.”

When protecting against simultaneous inflation and recession risks, Kieran says it’s important to understand those specific risks in your portfolios.

“You need to determine key client/portfolio risk,” says Kieran. “Asset allocation and portfolio construction risk mitigation strategies may differ based on the type of portfolio. For example, conservative, income generating portfolios will be more impacted by inflation, whereas high growth portfolios with longer timeframes will be more impacted by large drawdowns from growth declining.”

Kieran adds that it’s also important to consider the wider conditions of the market, such as whether you expect inflation to spike and then revert lower, or stay higher for a sustained period.

“Other considerations include whether a slowdown in growth is expected to be short lived or longer lasting,” he says. “And it’s important to get a handle on how central banks are going to respond to market conditions. That can be quite difficult to do when factoring in things like Government elections.

“You also have to look at fiscal policy, and what the potential fiscal response might be to specific issues. That’s because you can have monetary policy going one way and fiscal policy going a different way. And don’t forget to consider conditions affecting other regions, too.”

In an environment where uncertainty has increasingly become the norm, it’s the view of Andy Gardner — Portfolio Manager at Fiera Capital — that the equity sleeve of portfolios should comprise of sustainable and resilient companies that can withstand market shocks. In this respect, he believes a ‘fundamental’ approach to investing can do some of the heavy lifting in meeting the challenges of delivering both returns and managing risk in a portfolio.

Andy believes fundamentals help to drive long-term returns and are the first line of defence in a downturn, making this approach to investing an ideal way of protecting portfolios from the risks of inflation and recession.

“At Fiera Capital, we believe the majority of long-term portfolio returns should be largely attributable to superior compounding of earnings and dividends (fundamentals), not valuations,” he says. “Our analysis shows that portfolio fundamentals have been more stable through market cycles than the comparable universe of stocks. This has been a valuable source of risk reduction through those cycles.”

He says fundamentals do matter in a portfolio. Investors are able to invest in companies that have an established track record of delivering on the dual challenges of providing consistently good returns, as well as managing risk. An example of a company that meets this criteria is the luxury goods company, Hermes International (EPA: RMS).

“Hermes is the definition of pricing power,” says Andy. “As a business, it offers a competitive advantage, has a strong runway for growth, has a capital allocation strategy that reinvests back into the brand, impeccable financials, and cashflow predictability.

“This is a good example of a sustainable and resilient company that can withstand market shocks, while providing strong returns. It’s the type of company we like in an environment of uncertainty.”