risk-danger

Your client probably understands that stocks are risky; however, risk doesn’t stop there. Focusing exclusively on equity market risk while ignoring other types can have negative consequences for portfolios.

“Investments that are lower in equity market risk can often have higher risk from other factors or exposures,” says a market insight report from Richardson GMP. “Trading one risk for another, which may still be beneficial for a portfolio, still has other risks that should be acknowledged.”

Understanding those other risks will result in fewer surprises for investors. Says the report: “Surprise risk—one to which you didn’t think you were exposed—is by far the worse risk out there.”

Courtesy of Richardson GMP, here are additional risks and considerations for investors beyond equity market risk:

  • Purchasing power risk. While adding bonds to a portfolio reduces overall equity market risk, it increases the chance of losing purchasing power over time. Take the Canadian bond universe, which has a weighted yield-to-maturity of 2.75%. If inflation rises or you invest in shorter duration bonds with a lower return, you’re likely trading equity market risk for inflation, or losing purchasing power over time.
  • Credit risk. As bond yields have fallen, investors have turned away from government bonds, sliding down the credit curve in search of yields, increasing a portfolio’s risk.

Read: Why rising yields and market volatility are good signs

Plus, “With credit spreads being historically low (yield on investment grade or high-yield bonds over government bonds), it does raise the question whether investors are being adequately compensated for taking on credit risk,” says the report. And with the bull market being more than eight years old, credit exposure may become a more pertinent risk, as the potential for a recession increases.

  • Interest-rate-sensitivity risk. This is a relatively new type of risk for many investors, as bond yields have steadily declined over the past few decades.

“However, after bottoming in 2016, yields have been trending higher, thus impacting more interest-rate-sensitive investments,” says the report. “Bonds fall into this category, but so do many dividend-paying equities,” such as utilities, telecoms, pipelines and real estate companies.

Of note, the report reminds investors that low volatility strategies focused on equity investments that have historically lower equity market risk have traded equity risk for interest-rate-sensitivity risk.

  • Sector or stock selection risk. This risk tends to be greater with style-based investing.

“Tilts in a portfolio that focus on one style may reduce some types of risk but elevate sector or style risk,” says the report. “Ask any value manager these days.” Growth stocks outperformed value substantially in 2017 based on S&P 500 style indices.

Stock selection risk is also a big part of portfolios that use alternative strategies, such as long/short. “The longs need to go up, while the shorts need to decline,” says the report. “Clearly, which stocks are long or short become the key risk driver.”

Read: Mackenzie to launch first mutual fund in Canada to use alt strategies

Bottom line: “Risk is not a bad thing,” says the report—otherwise, investors would see no returns at all. But what is bad is “not knowing the risk a portfolio or investment is subject to.”

Geopolitical risk with oil

Weekly commentary by BlackRock focuses on the risks faced by oil right now. Specifically, geopolitical risks are top of mind.

“A rise in Persian Gulf-related geopolitical risks has helped fuel double-digit gains in oil this year,” says Richard Turnill, global chief investment strategist at BlackRock, in the commentary.

He says investors seem to be pricing in potential for supply disruptions if the U.S. doesn’t extend its waivers on Iran oil sanctions, plus there are worries over proxy wars in the Gulf region.

“This geopolitical risk premium comes amid OPEC production cuts and firming global demand for oil thanks to the global expansion,” says Turnill. “It also may explain why recent higher oil prices have not been associated with strong performance in other risk assets, a break from the past two years.”

Read: What investors should know about oil and geopolitical risk

He sees a stronger case for energy equities over crude. One factor supporting that view is energy firms’ focus on capital discipline.

“Unlike in some past oil market rallies, companies are not making huge investments in future production,” says Turnill. “Instead, they are using free cash flow to return capital to shareholders via increased buybacks and dividends.”

Read: Higher prices mean it’s time for ‘torquier’ oil names

Plus, current oil prices offer potential upside for energy firms’ earnings and stock prices. “Most energy companies have budgeted for mid-$50s oil prices in 2018, with this conservative outlook reflected in share prices today,” says Turnill. “This points to valuation upside should current levels of oil prices be sustained.”

He likes exploration and production firms and midstream companies, as well as energy stocks in emerging markets.

For more on playing the oil rally, including the risks, see the full BlackRock report.

For full investment risk details, including risk metrics, read the full Richardson GMP report.

Originally published on Advisor.ca
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