Reframing risk: no more having your cake and eating it

A row of cupcakes with minty coloured icing and sprinkles on top
For financial professionals only

Risk and return are the classic investment trade-off. If you want the potential for more return, you’re going to have to accept more risk. If more protection and a smoother journey is your priority, it will likely come at the cost of long-term performance.

Finding the right trade-off is an important step for a client, and key in the relationship with their financial adviser.

But investment trade-offs can, and do, break down at times - sometimes for extended periods.

Protection and performance

Take Gilts for example. As yields fell over the course of many years, clients enjoyed the defensive qualities of Government Bonds, while collecting a healthy annual return. Ideal.

At Parmenion we use a 20-year data set to frame our asset allocation decisions and stress test our models – this shows the average annual return for Gilts to the end of December 2021 is 4.95%. Great if you’ve been invested, but realistic now? Probably not.

The sharp rise in yields we’ve experienced in 2022 has meant large capital losses for bond holders. And while I don’t expect that trend to continue to such extremes, neither do I expect a return to the previous equity sized returns.

Beyond just losing money, a big issue is that the largest holders of bonds are generally lower risk clients, i.e. those with less tolerance or capacity for loss. Performance this year within Fixed Income has been far worse than expected due to the speed at which yields have risen in response to the highest inflation levels in 40 years. This, amplified by the above average returns we’ve become accustomed to, can make explaining quarterly valuation statements a real challenge.

Unless we expect yields to grind back down towards zero, a reframing of expectations feels prudent. Government Bonds can still be an important part of a portfolio, but as a return generator, are likely to take more of a backseat.

If it’s an adviser’s job to help clients readjust to this, then it’s the job of an investment manager to maximise what can be done. Buy and hold has been a straightforward and successful strategy since the global financial crisis, but this new regime requires more tactical nous. Whether it’s varying credit risk, duration, or regional allocation, we need to add value where we can.

Good conscience, good returns

For as long as I can remember, until about a year ago, Ethical solutions led the way on performance. There will be various reasons for this, linked to both investor sentiment and market dynamics. Ultimately, this has probably been a good thing in terms of channelling money towards more sustainable companies. But assuming ESG and better performance go hand in hand isn’t necessarily the case. And as with Governments Bonds, 2022 has shown us this.

That isn’t to say performance won’t revert, and sustainable strategies won’t rise back to the top of the rankings, but trends change and it’s wise to consider ESG returns as ‘different’ rather than ‘better’. The strong performance of traditional energy stocks this year, typically not held in sustainable portfolios, has highlighted a clear performance trade-off for many clients.

This is fine for those with clear ethical preferences and a portfolio to match. It’s part of the journey and benefitting from oil exposure returns would likely feel uncomfortable. But anyone that lets performance lead their choice of ethical portfolio might think differently. It’s important to be clear that as different sectors and styles come in and out of favour, performance will vary from that of the broad market.

Expectation is everything

Trade-offs are no bad thing. They keep things in balance and allow people’s judgement and preferences to come through. Whether selecting a Risk Grade or deciding between ethical solutions, choice is an important aspect of the way we work at Parmenion. We want to create positive investment outcomes for as many different investors as possible, whilst providing you with the tools to support your clients. Keeping expectations practical and current is essential. 

Find out more about Parmenion's approach to environmental investing here

This article is for financial professionals only. Any information contained within is of a general nature and should not be construed as a form of personal recommendation or financial advice. Nor is the information to be considered an offer or solicitation to deal in any financial instrument or to engage in any investment service or activity.

Parmenion accepts no duty of care or liability for loss arising from any person acting, or refraining from acting, as a result of any information contained within this article. All investment carries risk. The value of investments, and the income from them, can go down as well as up and investors may get back less than they put in. Past performance is not a reliable indicator of future returns.  

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