StJohn Gardner, Chief Investment Officer, offers views this week on the benefits of active diversification in times of stress, the importance of good currency management and how, over the long term, the different responses to events of the various types of investible assets usually helps in reducing portfolio risk as a whole.
Risk management is central to achieving investment returns in an optimal way. Central to this is a portfolio manager’s ability to allocate capital across a wide array of assets exhibiting different reactions to market events.
Wealth managers are often restricted to marketable instruments and thus to buying stocks, and bonds, typically through collective vehicles such as exchange traded funds (ETFs) and investment trusts. Funds, managed and issued directly by asset management houses allow property, commodities, hedge and other alternative strategies to be invested in with a different risk profile to their more market sensitive investment trust counterparts. Funds provide a truer reflection of the price volatility of the underlying assets than market tradeable investment trusts which can deviate in price significantly from their underlying net asset value and thus exhibit risk more akin to the equity markets, regardless of the underlying, at times of stress. At Sandaire we can add further diversification of risk through direct property transactions and our private equity expertise.
In some of the more extreme periods of stress, investors bail out of anything they can liquidate quickly and the usual positive, negative or muted correlations between different assets are upset for a period, often trending towards a 100% positive correlation as the assets are sold off indiscriminately. We saw such a phase in March where bonds and gold, (which usually enjoy positive investment flows and returns when equities sell off), actually fell in unison with equities and indeed all liquid assets, as asset owners’ focus was to build a war chest for unknown eventualities associated with the impact of the response to the pandemic.
Nevertheless, over the long term, the different responses to events of the various types of investible assets usually helps in reducing portfolio risk as a whole.
Often forgotten though, is one risk that affects all assets; and in fact it is one of the most significant risks. Currency.
Good currency management is essential. Some managers chose to eliminate the risk as far as possible by buying bonds issued in the investors home market currency and orchestrating a significant bias towards equities listed on their home market. But doing so narrows the opportunity set substantially and increases non-currency risks such as concentration and sector bias risks. At Sandaire we prefer to invest in bonds and equities across the world to ensure we take advantage of the best value bonds wherever in the world and in whatever currency they are issued and to ensure our clients have access to the global sectors we think will dominate equity returns over the forthcoming period. Currency management is then overlaid. Currency volatility is such that it would dwarf fixed income and hedge fund returns and thus upset the asset class diversification benefits, so this risk is hedged back to the client’s portfolio or home currency. On the other hand, equities exhibit a much higher volatility, and thus risk and return profile, and are ripe for currency management. With a global equity approach the default position is to build in the judgement of expected currency direction as part and parcel of the regional asset allocation decision process, thereby obviating the need to pay currency hedging costs on a continuous basis. Hedges can be placed as and when the investment team have a high conviction of an adverse movement versus the home currency. In this way, most of the time, currency fluctuations are adding to the diversification factors in any given portfolio and if actively managed can enhance returns. Not having a home bias to our equity allocation and not being hedged to home currency has allowed recent strength in the US Dollar and Yen to add to portfolio performance.