Spring 2010
Issue Features
- Managing Liquidity in the Private Equity Market
- Bringing DB Discipline to DC Investing
- Scrutinizing the Fixed-Income Landscape
- International Completion Strategies
Column: Voices
Departments
Column: Voices
When to Take on Risk in a Diversified Portfolio
By Robert Browne, CFA
— Robert Browne
Executive Vice President and Chief Investment Officer, Northern Trust
When is it appropriate to take on risk in a diversified portfolio? The recent crisis of confidence in Greece and the subsequent sharp volatility of the country’s government bond prices remind me yet again of one of my favorite truisms from the insurance industry: There is no such thing as a bad risk; there is only bad premium.
I wonder how many bond investors remembered this when they recently participated in an 8 billion euro new debt the Greek government issued in January. Initially, the deal was viewed as a success, but just two days later, investors had a change of mind as the realization of certain ugly facts took hold: a 12.7% fiscal deficit in 2010 and total debt to GDP rising to 135% in 2011. The newly issued five-year Greek government bond has been bouncing up and down in a five-point range as investors speculate back and forth on the prospects of a bail-out. That’s a lot of volatility for an intermediate investment grade bond, and I wonder if investors now feel the yield premium was worth the risk.
The intention of this commentary is not to discuss the woes of the Greek government or even its implications for the capital markets. Rather, it is to discuss how and where we should take on risk in a diversified portfolio. More precisely, I would like to talk about the role of each asset class.
The Role of Assets
There are four roles an asset can play in a portfolio: It can be a source of ready liquidity; generate reliable, high quality income; be a highly dependable store of value; or be a source of long-term capital return. It is the rare asset class that serves all four purposes very well; in fact, I cannot think of one.
Prior to the financial crisis, investors of all types were focused on “risk-adjusted return” as the primary goal for nearly all asset classes. What investors didn’t realize, or simply forgot, was that in practice risk-adjusted return is a concept that relates to the total portfolio and is not one easily applied to individual asset classes or single securities.
Reviewing Strategic Asset Allocations
As investors review their strategic asset allocations in the wake of all that has happened in the past few years, they should evaluate multiple portfolio outcomes over varying horizons and a wide range of scenarios. They should then review their tolerance for changes in portfolio liquidity, capital preservation, capital return opportunities and income stream in these scenarios. Designing asset class investment guidelines around the priority of these four objectives is the next step from an investment policy perspective.
The next time investment grade portfolio managers buy Greek bonds, they may want to check their guidelines with regard to liquidity and capital preservation objectives.
© 2013 Northern Trust Corporation
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