Please see article below from Quilter Investors received yesterday afternoon – 15/04/2021
The need to diversify
Quilter Investors chief investment officer, Bambos Hambi, explains why private investors need to diversify across different asset classes and different geographies.
Over the last 30 years or more, while the ‘average’ retail investor (if there is such a thing) has undoubtedly become more investment savvy, investment markets and the fund strategies that draw upon them have taken a quantum leap in both size and sophistication. Consequently, the chasm between the two has probably never been greater.
Even today, too few private investors really understand the need to diversify their savings across different asset classes and geographies and how this impacts the risks to which their financial futures are subject.
Given the constant media barrage, it’s hardly surprising that investor ‘champions’ such as the ‘FAANG’ stocks – namely Facebook, Apple, Amazon, Netflix and Google (Alphabet) – arise. A previous investor acronym that once attracted similar attention is the ‘BRICS’, which stood for Brazil, Russia, India, China and South Africa.
While both helped attract huge levels of new investment, anyone who plumped solely for these investment areas will have experienced a bumpy ride. By contrast, the essence of diversifying across a range of different risk categories is that it smooths the investment journey, enabling us to make more reliable plans for our financial futures.
Spinning the wheel
Many people still think of diversification in terms of eggs and baskets, but it’s a flawed analogy. In reality, the risk of concentrating your savings into a few leading tech stocks, or a group of ‘hot’ emerging markets, is much more akin to walking into a casino, putting your ‘egg’ on one number and spinning the roulette wheel.
A better analogy is to think of diversification in terms of cooking. Imagine an array of different pots bubbling away. While each one will come to the boil at different points, delivering the desired outcome, each could also boil over, or just go cold, if left unattended.
This is where a multi-asset portfolio manager comes into play. It’s their job to stir each ‘pot’ and see that it receives the right amount of heat, at the right time, to achieve the desired end result.
Over the last 30 years or more, investment markets and fund strategies have taken a quantum leap in both size and sophistication.
Active not reactive
Having a fully resourced portfolio manager at the helm is important because, as the table (see the pdf at the bottom of this page) shows, different asset classes and regions respond to economic events in different ways. Accounting for this requires constant monitoring, analysis and position refinements at the portfolio level.
Take UK property as an example. In terms of investment returns for the 11 asset classes listed in the table, UK property had yo-yoed from last place in 2016, to first place in 2018 and back to last again by 2019.
Meanwhile, UK equities, which have never placed higher than fifth in the last 10 calendar years, proved to be the worst performing asset class of 2020, thanks to the onset of the pandemic and the last thrashes of the Brexit farrago.
By contrast, the pandemic, and the speed with which China was able to deal with its fallout, helped to propel Chinese equities into first place in 2020. They were also the best performing asset class in 2017 (but the worst in 2018).
Creating solutions
Thanks to our scale and reach as an investment business, we begin with a universe of many thousands of different strategies and fund structures and whittle it down to find the ‘best of breed’ in each space.
This means our portfolio managers and investment teams spend the majority of their time researching, analysing and modelling to find those managers who can demonstrate the most consistent returns for the level of risk with which we’ve entrusted them.
As dedicated portfolio managers, we have two key advantages over investors who decide to manage their own investments. The first is the time, expertise and expense required to actively monitor global markets, to decide which asset classes are best suited to the conditions and to identify those managers that consistently do the best job in each asset class.
The other great advantage we have is access. Unlike private investors, we have access to a huge swathe of investment managers and strategies from around the world covering every major equity and bond market. Often we invite proven managers to create dedicated funds (called mandates) that are run especially for us.
We also have access to a whole universe of fund strategies that either aren’t available to UK investors, are too sophisticated for private investors or which require minimum levels of investment that put them far beyond the reach of ordinary investors. This is especially so in the case of so-called ‘alternative investments’.
Alternative thinking…
The term ‘alternative investments’ covers an enormous global investment industry that’s all but closed to private investors. Alternative investment funds cover the widest range of asset classes from commodities like gold and oil to other ‘real assets’ such as commercial property, infrastructure and renewable energy.
They also include hedge funds that invest in all manner of asset classes but which, thanks to the complex derivative strategies they employ, can pursue all manner of different instruments. Many of these focus on generating returns that have a low ‘correlation’ to those of equity or bond markets, others focus on delivering consistent ‘absolute returns’ whatever the investment environment.
Having access to such diversity allows us to reduce the correlation of our holdings both with one another and with major global equity and bond markets. This means that if, say, a global pandemic broke out and sent equity markets into steep decline, as was the case in 2020, other holdings, not correlated to equity markets, could take up the strain.
Unlike private investors, we have access to a huge swathe of investment managers and strategies from around the world covering every major equity and bond market.
Diverse times
Recent months have provided ample illustration of the need to properly diversify portfolios.
The unprecedented events of 2020 ended with one of the greatest relief rallies on record, thanks to news of three viable coronavirus vaccines. Within this, ‘value stocks’ that had been in the shadow of ‘growth stocks’ for almost a decade began to outperform as investors rotated into those areas previously left behind (see the inset box).
Only weeks later, the headlines were dominated by news of rocketing government bond yields and major losses for bond investors as markets began to price-in ‘reflation’ – the period of rising prices and growth that tends to follow a period of ‘deflation’ (falling prices and growth), like the one caused by lockdown.
On the whole, reflation is a welcome sign for long-term investors like us, as it shows that an economic recovery is well underway and that improving economic growth lies ahead. However, bond markets naturally recoil at the prospect of the higher inflation and interest rates that might accompany it.
Not only did lower-risk bond investors feel this in the pocket, but investors at the other end of the risk spectrum, namely, higherrisk ‘growth investors’ in equities, also suffered. The so-called FAANGs and other leading tech companies were among the early casualties.
This is because growth stocks tend to struggle with the risk of higher interest rates and inflation; as a high level of their predicted profits lies in the future, the prospect of higher interest rates reduces their value today.
While all this was going on, smaller companies began to outperform as they tend to enjoy reflation.
These issues (and too many more to mention) have already exposed investors with too little diversification to significant volatility and potential losses so far in 2021. .
This underlines the ‘smoothing’ benefits of a well-diversified, global portfolio. When changes in the economic cycle or the broader tapestry of society take hold, the diversified investor doesn’t need to ‘run out’ and find a solution because it’s already simmering away somewhere in their portfolio.
Understanding ‘value’ and ‘growth’
In general terms, ‘value’ investment approaches target those companies regarded as looking cheap relative to the value of their assets (also known as their ‘intrinsic’ or ‘book’ value). Value stocks tend to be well-established businesses, which often offer high levels of dividend.
Good examples of value stocks include banks, oil and mining, utility and industrial companies although any company whose valuation is below the market average is technically regarded as a ‘value stock’.
Meanwhile, ‘growth investing’ is more focused on capital growth than on collecting dividends. Growth stocks tend to be younger or smaller companies whose earnings are expected to increase faster than those of other companies in their industry sector or the broader market.
They tend to pay limited dividends as they are busy reinvesting their profits in growing their businesses.
Growth stocks are most commonly found in the technology sector with companies like the ‘FAANGs’ the most prominent example of recent years.
Other ‘cyclical’ areas (meaning companies most impacted by the economic cycle) such as consumer goods, leisure and travel or the automobile sector often contain ‘growth’ stocks. The same is true of areas like biotech.
Ultimately, any company with a disruptive business model, ground breaking new technology or an irresistible new line of consumer goods can find itself classified as a ‘growth’ stock if its earnings growth starts to outpace the broader market.
As companies mature and become more established in their industry niche, they naturally evolve from being growth companies into being value companies. That is, until they bring something new to the market, at which point the cycle can begin all over again.
Interesting input from the CIO at Quilters. A lot of this is what we discuss daily with our clients. We need diversification by assets, geography, and styles. Good strong ‘Active’ and ‘Tactical’ fund management helps too, particularly in volatile markets.
As IFAs we use a wide range of investment options for our clients to meet their objectives and risk profiles. We have a myriad of choice.
Please continue to check back for our latest blog posts and market updates.
Charlotte Ennis
16/04/2021