Dare to be different

Dare to be Different – Why Volatility Matters

Investor optimism, reason for caution – an update on financial markets

Whilst the first half of the year gave us plenty to process — from banking turmoil to a morphing yield curve, the global economy performed well. US equities had a particularly strong year, with the S&P 500 up 15.8% through to mid-June, bouncing back from a two-year low last October and shifting from bear to bull-market mode. This has largely been technology led, with the Nasdaq rising more than 40% year-to-date. Much of the equity market’s gain can be attributed to just a handful of companies, led by NVIDIA, which saw strong chip sales as interest in AI built. Goldman Sachs estimates that AI could lift global GDP by 7% and productivity by 15% over the next decade – a gain of more than double average annual global GDP growth.

We are currently seeing inflation and supply-side issues continuing to ease, as central banks near the end of their projected tightening cycles and wait to assess the impact on the economy. So far, economies have proven resilient in the face of rapidly increasing interest rates, with growth generally holding up and unemployment remaining at very low levels. Last week, the International Monetary Fund slightly increased its estimates for 2023’s global GDP growth as they forecast a reduction in inflation. They forecast global headline inflation falling from 8.7% last year to 6.8% this year, and a further fall to 5.2% next year.

The market strength of 2023 has aligned with the potential “soft landing” scenario, where rising interest rates successfully reduce inflation without causing a recession. However, there remains a number of potential upside and downside risks to the economy and financial markets. These most notably include the risk of inflation persisting and potentially resurging, as well as further geopolitical issues in both Europe and between the US and China. Many yield curves are now inverted and are pricing in rates falling, with growth expected to slow throughout the remainder of 2023.

How our strategies have been positioned

Our global equity exposure performed well in 2023. Our allocation to a fund manager with a value bias and overweight to Japanese equities, which has been one of the strongest share markets this year, did particularly well. Likewise, our emerging markets fund manager benefited from its broad mandate and the ability to invest in companies both based in emerging markets as well as those with significant revenue exposure to these countries. This fund significantly outperformed the MSCI Emerging Markets Index over a one-year period. Pāua Wealth’s strategic underweight to Australasian equities has been useful, particularly given the region’s performance lagged that of global equities.

With significantly higher yields to a year ago, bonds have become more attractive, providing income to investors as well as some downside protection in the event of falling interest rates. Our client portfolios retain their exposure to alternative fixed interest, given the diversifying and inflation-protecting role it continues to play.

The divergence of performance between shares, bonds and alternatives in 2022 has provided a useful opportunity for clients to rebalance throughout 2023, taking some profit off the table to reinvest into other assets at lower prices.

Performance of Pāua Wealth Management’s strategies

Whilst we do bespoke portfolios for clients, we actively monitor performance of our strategies against various benchmarks and reference portfolios. Pāua Wealth Management’s strategies continue to outperform their benchmarks and reference portfolios over all time periods i.e. the quarter, 1 year and 3 years. We’re particularly proud of the fact that we have achieved this outperformance with lower volatility, which is what we aim to do i.e. achieve better risk-adjusted returns.

Over the short-term, the sharp rebound in global equities has been the main driver of returns, particularly a satellite exposure to a high performing high-growth fund. Over the longer term, strategic asset allocation decisions have been the main contributor to outperformance, which are made by our Investment Committee. These include fund manager selection, exposure to alternatives, our underweight to property and currency hedging strategy which have all been important drivers of alpha in client portfolios. Independence, challenge and long-term thinking pays off.

For example, we decided at our Investment Committee that strategically our global equity exposure would be unhedged to the NZD, unlike most of the market. The US dollar performed strongly in 2022, which provided some currency gains offsetting falls in share markets, so we decided to take some of this profit and hedge a proportion. Increasing the New Zealand dollar hedging within portfolios locked in some of the currency gain for clients, whilst also hedging against a reversal in the relative strength of the USD. Given New Zealand’s higher interest rates relative to the MSCI currency basket, the ‘carry’ (the interest rate differential between two countries) is now back in place. Keeping the majority of our global equity exposure unhedged can help protect against downside risks for New Zealand, given its current account deficit and relatively poor economic outlook.

Why investors must focus on risk-adjusted returns

We focus on risk-adjusted returns for good reason. As an investor, you want to be appropriately compensated not only for the risk you take but ensure your investments fit within your appetite for risk.

One way to highlight an investment’s risk-adjusted returns is through annualised volatility. Annualised volatility shows the price fluctuations of an investment over a year. The higher this number is, the more volatile the investment and the wider range of potential outcomes. Comparing the annualised volatility of different investments can help gauge which are riskier and which are more stable.

Using the performance of a Pāua Wealth growth strategy as an example, over a three year period, this returned 6.9% per annum with an annualised volatility of 7.1%. To gauge the risk taken, we can compare this with the performance of the NZX 50 Index, representing New Zealand’s top 50 public companies, and Morningstar’s Multisector Growth Index, a diversified and comparable composite of seven indices weighted and calculated by Morningstar. The NZX 50 Index returned 2.1% over the same three-year period, with an annualised volatility of 11.5%, significantly underperforming the Pāua Wealth portfolio whilst taking more risk. The Morningstar Multisector Growth fund returned 6.1% per annum with volatility of 9.5%. This diversified composite also both underperformed the Pāua Wealth growth strategy whilst taking more risk.

Comparing the Pāua Wealth growth strategy relative to these two indices highlights the importance of comparing returns, adjusted for risk, to ensure you are appropriately compensated for the volatility you’re exposed to and that your portfolio fits within your tolerance for risk.

We aim to ensure our clients are invested so that their investment portfolio performance not only has the best chance of achieving their goals, but aligns to their appetite for risk. We do this by creating a strategic asset allocation (‘SAA’) aligned to what our clients are trying to achieve and selecting investments and fund managers to increase diversification through different asset classes and investment styles which seeks to generate out-performance over time but also provide downside protection.

If you’d like to find out more about our approach and how we’re different, please feel free to email info@pauawealth.com.

Past performance should not be taken as an indication or guarantee of future performance, and no representation or warranty, expressed or implied is made regarding future performance.