Reports

The Truth About Risk and Reward – Portfolio Management

In order to match the investment with the investor, the investment advisor must first consider the investor's risk profile. The investor is then classified as Defensive, Conservative, Moderate, Growth or Aggressive. Similarly, funds are structured according to their industry classification for risk. The industry classification system proposes that the more risk a fund is prepared to assume the greater is the potential for higher returns in the longer term. Higher Risk – Higher Return. An analysis of the investments in the funds categorised as higher risk funds reveals a higher percentage of tradable securities in the investment portfolio. The assumption that risk increases when the proportion of shares and financial instruments in the portfolio increases is too simplistic. Whilst it is obvious that the portfolio holding a high proportion of shares has a greater exposure to market fluctuations than say a fixed interest portfolio, this is only part of the equation for assessing risk. Risk is represented by the following equation:

Risk = % Assets Exposed to Markets x Tolerance Limit for Market Variance

Two different funds with the same asset allocation may have entirely different exposures to risk. A fund that adopts appropriate risk reduction strategies will in fact increase its returns; that's Lower Risk - Higher Return. A long-only fund with a passive investment strategy and with little or no portfolio cover is very exposed to major market adjustments. Management of portfolio risk is the single most important variable in fund performance.

And so the advisor tells the investor that high returns necessitate greater risk. These risks are the cost to the investor for the prospect of higher returns. The investor is told that higher returns are a longer term prospect, that's in case the share market declines in which case the investor may have a long wait to recoup his initial investment. The high risk of these funds stems from the failure of the funds manager to manage risk. There are many financial instruments and strategies to manage this risk. The truth is that an actively managed long short fund should actually increase its return during a decline in the index. The fund manager however, is only required to adhere to the mandate set out in the governing deed and Product Disclosure Statement. Accordingly the manager adopts a passive macro approach and is primarily concerned with preserving the asset allocation ratio, say 90% in shares, 10% fixed interest, irrespective of the market direction. These long funds generally plan to ride out the market retracements. After all, most markets will eventually make new highs. By actively trading at a micro level and through the prudent use of derivative products and profit centres, the fund should exceed the expectation for a high return, at the same time reducing the level of risk. This requires that competent investment management is maintained for all instruments in the portfolio. The funds macro performance will then be the sum of individual instrument performances.

The risk associated with investment in shares is increased by the decision not to actively trade or cover both sides of the market for each instrument within the portfolio. Markets go up and markets go down. Both these moves offer the opportunity of gain. Ignoring this simple market truth exposes the fund unnecessarily to higher risk.

(For a comparison of Long Only vs. Actively Traded results using the Trade Mechanics micro trading system refer to the Performance Page).