Jun 22, 2020
COVID-19 and the worldwide lockdown of economies are having a huge impact on GDP growth. It is forecast that the world will enter the worst recession since the Great Depression, just over 90 years ago. This has caused extreme volatility in markets. The sell-off we saw in February and March this year, was the fastest 30% drawdown in history. It took just 22 days for the market to fall 30%. Global markets bottomed during the last week in March, and since then, we’ve had a huge rally in markets. There has been much speculation on the shape of the economic recovery. Most market commentators expected a U or W, but more recently, the swoosh has become a contender. But no matter what recovery we expect, you cannot build a portfolio based on a letter or shape.
Markets have not only been extremely volatile this year, the behaviour of some asset classes has also surprised investors. Both equities and bonds sold off significantly in March, even though they tend to behave differently to one another. Previously, SA property stocks and SA bonds were correlated, but this relationship seems to have broken down for now. Property companies might not be paying dividends for the foreseeable future and are behaving more like ‘SA Inc’ stocks than income-generating assets. Given the market conditions we have faced over the last few months, does this change how we should think about portfolio construction? The short answer is ‘no’.
The impact of the coronavirus on global markets has illustrated again how important it is to have well-diversified portfolios that can weather storms and stay aligned with your clients’ investment goals. It’s crucial to build client portfolios that can withstand all kinds of environments, because we never know when the weather will turn. It’s not about avoiding risk but managing it.
While you want to participate in rising markets, your portfolio should also mitigate volatility in the bad times. Building portfolio resilience does not just happen by blending a few funds. It’s built intentionally, by selecting suitable, complementary funds to maximise risk-adjusted returns across market cycles.
What are some of the key characteristics to consider when blending funds in a portfolio?
Risk cognisant. The investment manager needs to skilfully manage risk and volatility. A key question is: Does the manager protect the portfolio on the downside while providing meaningful upside participation? Assessing a fund in terms of risk, means you should look at data such as the beta of the fund (sensitivity to markets), how volatile the fund is (standard deviation) and maximum drawdowns.
Diversified. You need to look at combining funds that can outperform over all cycles. Consider how well funds will work together, the number of funds required to achieve proper diversification, the style of funds, how correlated the funds are and what their alpha signatures are (active returns). For example, if you only choose funds that are passive or which are very sensitive to how markets perform, you will not achieve diversification, even though you may be combining many funds in one portfolio. You want a blend of funds that will do well at different times. It’s also important to be aware of concentration risk. Having multiple sources of return is key. Diversification benefits are also limited beyond a small number of funds. Our research shows that 3-5 funds are sufficient to achieve diversification, if chosen correctly (assuming a moderate correlation between assets).
Flexible. Does your portfolio have the ability to take advantage of changing market environments and opportunities? It’s important to understand which funds perform well in each market cycle and environment. Putting suitable funds together, ensures your portfolio will be like our Springbok rugby team – stronger together! Even after you’ve picked your fund blends, ‘your team’, consider having one or two funds on your buy list, ‘your reserves’. Should the market environment change to one where a particular fund in your portfolio should outperform, you could consider making some tweaks and upweighting your allocation to that fund. Alternatively, there might be a fund ‘on the bench’ which you could include to improve the risk-adjusted returns of your portfolio. So, be flexible how you manage your portfolio through the cycle.
Proven style and consistency. Avoid those flash-in-the-pan funds that have done well over the last year and concentrate on a performance track record over a full market cycle. It’s interesting to note that more than two-thirds of SA unit trusts funds haven’t been through a market crisis until now. The number of unit trust funds has grown exponentially since the global financial crisis. Currently, there are 1445 SA unit trusts funds, versus 519 funds which were around before 1 October 2008. Ask yourself: Has the manager delivered value over a full market cycle? Measure and monitor your managers to ensure they are sticking to their style and fulfilling their role in the portfolio.
Figure 1: What are you looking for when building a portfolio?
Source: Ninety One SA.
As outlined above, there are many factors to consider when constructing a resilient portfolio that can perform through the cycle. You need to look at a variety of elements such as fund correlations, style, volatility/risk management, track record and return signature. Tapping into the relevant data can make all the difference between only having a ‘street view’ versus having a full satellite image. In a recent webinar, Ninety One shared some examples on using data to optimise portfolio construction. Watch our webinar recording to gain more insight into this important topic.