Written by Justine Morton, Senior Investment Advisor
I don’t often get lost for words, but I must admit to having been completely taken aback when I recently read an article in the Australian quoting the CIO of a large industry super fund who was presenting at an industry conference and stated that “for a long time we all just forgot about diversification”. For any professional adviser or investment manager to state this was quite unbelievable. Diversification is a founding principle on which we rely to protect and preserve our client’s capital. It is a key component of Modern Portfolio Theory, and so important that Australian Superannuation Legislation operating standards explicitly require that SMSF Trustees consider diversification when constructing investment portfolios.
Modern Portfolio Theory (MPT), pioneered by Nobel Prize winning American Economist Harry Markowitz, proposes the use of diversification to construct an investment portfolio to achieve the optimal mix of high risk (high return) and low risk (low return) investments to generate the highest return possible for the risk tolerance of the investor. A critical point is that based on statistical measures, such as variance (volatility) and correlation (the degree to which one investment’s price moves in relation to another investment’s price), a single investment’s performance is less important than how it impacts the entire portfolio.
The end goal is to create an optimal portfolio that will maximise performance for the investor based on their tolerance to risk. It is the acceptance of the wisdom of MPT that has led to institutions globally labelling their investment options as Balanced, Growth, High Growth etc reflecting the weighting of growth assets (equities, property etc) and defensive assets (fixed income, gold, cash etc).
When seeking to generate investment returns there are three sources of returns:
- Asset allocation – the diversification of investments across different asset classes (equities, fixed income, private equity, infrastructure, property etc)
- Investment selection – asset, fund or manager
- Market timing
Of the three, market timing is the most difficult to optimise consistently and with any degree of confidence. It is for this reason that we tend to use a staggered investment approach to manage market timing risk and see any performance generated from getting timing right as a bonus rather than as an expected return.
The return source attributed with generating the most consistent and reliable returns is asset allocation. Depending on which research you review, asset allocation is deemed responsible for 70 – 90% of the performance generated by a portfolio. In other words, get your asset allocation right and you are on the way to optimising the performance of your investment portfolio for the risk that you are prepared to take.
It is worthwhile pausing here to stress that the key here is performance for level of risk. Any performance number quoted relies on the investor staying the course with an investment. It is for this reason that we spend a huge amount of time with our client’s focusing on understanding the purpose of their wealth (legacy vs cash flow vs philanthropy vs fun etc) and how comfortable they are with taking risk (seeing their investment portfolio going up and down substantially) before we start to think about asset allocation and portfolio construction. If we don’t get the level of risk right and they are not comfortable to stay the course, the benefits of asset allocation or investment selection will be eroded.
Most investors will be used to seeing their portfolios broken down into asset classes and geographies – Australian equities, international equities, property, fixed income etc. But this is where things get interesting. Simplistically, you might think that having investments spread across a range of asset classes would do the job of diversifying your portfolio and setting you up for consistent performance. However, as many people have discovered this year, just spreading investments across asset classes is part of the story and misses the critical factor. What is important in diversification is correlation.
Correlation – “a mutual relationship or connection between two or more things”
Or in relation to investments, the degree to which one investment’s price moves up or down as another investment’s price moves up or down.
If two investment prices track each other perfectly then they’ll have a correlation of 1. If they move equally in opposite directions, they’ll have a correlation of -1.
When we are constructing client portfolios, we break all assets down into growth or defensive assets.
Growth & Defensive Assets
A growth asset is typically an asset that has a high return capability and that exhibits high volatility of pricing. Typically, it’s an asset that is highly correlated to equities and the economic cycle. Equities have historically produced the largest returns of all asset classes and had the highest volatility; so, they are the benchmark to which we often refer when constructing a portfolio. Just adding fixed income investments to equities will not necessarily reduce the risk of your portfolio (as people have discovered this year). Different types of fixed income investments are growth investments, while others are defensive.
High yield and emerging market fixed income for example, typically have a high correlation to equities, and this correlation increases (as does their volatility) in times of market stress. So, although these are both fixed income assets, we classify them as growth assets. Government bonds however, are an investment that has a low correlation to equities over the long term which becomes increasingly negative in times of stress and tend to have lower returns and lower volatility. We therefore consider these a defensive investment.
Equity hybrids or Cocos, which you may have in your portfolio, are interesting in that they typically have a lower correlation to equities of around 0.4 in a normal or stable equity market. However, in times of market stress (think the GFC or Covid in 2019), these investments start to exhibit volatility like an equity and correlation moves closer to 1. Thus, we classify them as a growth asset.
I could give numerous other examples, but it is these nuances as to why we have seen supposedly diversified portfolios see large drawdowns this year similar to what we have seen in equity markets. Not enough attention has been paid to the underlying characteristics of the investment sub-sectors and how they perform in relation to equities in times of stress. As per the CIO quoted by the Australian, many investors had forgotten about what constitutes true diversification.
In addition, investors must be wary about the sources of return being targeted in your portfolio as these will also influence correlation and the defensive nature of your portfolio. For the past 10 – 20 years we have seen markets that have benefitted from reducing interest rates, high levels of liquidity and general political stability. There is a saying a “A rising tide lifts all boats”. The lack of discipline and focus on portfolio construction by portfolio managers could be hidden by the largely supportive market conditions, where just being invested in a range of assets was sufficient.
Warren Buffet summed it up perfectly, “You never know who’s swimming naked until the tide goes out”. Well, the tide has gone out and we are now seeing dispersion of returns from investments both within asset classes and between asset classes like we haven’t seen for years. This has had huge implications for portfolio construction, and we are seeing a broad range of investment returns showing clearly which portfolios have been constructed robustly and those that have not.
For example, if you have a growth bias in your equity portfolio, investing in bonds and going long duration will mean that the diversification benefits will be far less than if you have a value bias in your equity portfolio and include bonds to diversify.
Another example: having 6 different investment managers managing Australian equities with a growth bias will not provide the same diversification benefits as investing with 3 different managers with different strategies (value, growth, core). Do you have large cap and small cap investments in your portfolio? Sector and geographical diversification? Have you thought about currency and liquidity? True diversification is a fine balancing act.
Capital Preservation & Tactical Asset Allocation
Diversification is the key defence mechanism we have in our investment arsenal to protect and preserve capital whilst targeting returns. At Providence we have never been as (truly) diversified in our client portfolios as we are today, and our priority is as always to protect our client’s capital. Why? Through the paradox of percentages, if your portfolio goes down by 20%, you need it to then go up by 25% just to get back to the same position. If it goes down by 30% you need it to go up by 43% and if it goes down by 40% you need it to go back up 66.5% just to get your money back. Additionally, managing volatility and drawdown assists greatly in overcoming behavioural biases that can have damaging consequences to the long-term portfolio outcomes. For example, selling assets at the wrong time.
So, we spend a huge amount of time as I mentioned earlier, getting our Strategic Asset Allocation right for each individual client with their own goals and risk profile. Then we draw on the extensive brain trust that is our Investment Committee, to get the Tactical Asset Allocation tilts in place and to ensure that our portfolios are not only truly diversified but also structured to meet the unique demands of market conditions at that moment in time.
A good example of this has been our positioning in government bonds this year. Whereas typically government bond prices go up as equity bonds sell off, the unique situation of rising interest rates and inflationary concerns has seen government bond prices fall just as equity markets have. In addition, global equity markets held significant duration risk prior to recent times due to the dominance of US tech/growth names in global equity indices. When structuring client portfolios we considered not only the duration within government bonds, but also hidden within other asset classes*. This resulted in us being tactically underweight US equities and underweight government bonds coming into this year, protecting our client portfolios from significant losses. An increase in defensive alternatives provided a non-correlated return stream. As the economic and market conditions have changed, we’ve been adding government bonds and are watching closely for when to adjust our view on US equities. Just as important as Strategic Asset Allocation is Tactical Asset Allocation.
Investment & Fund Manager Selection
Once all the above is considered, it is only then that you should focus on investment and manager selection. This is the second most important source of performance return, and we do a huge amount of in-house fund due diligence at Providence to ensure that we make the best decision we can in selecting managers for our clients (You can request a copy of our latest Activity Report here https://providencewealth.com.au/activity-reports/). In this process we are however, always thinking about if we invest with a manager, how will it impact the diversification of the portfolio and enhance portfolio construction – it is a high benchmark to be added to our portfolios!
We won’t always get it 100% right, but this focus on true portfolio diversification and rigor in implementation, has provided consistent long-term performance for our clients. Returns just a little lower than long term Australian equity market performance, but more importantly, significantly reducing drawdowns and portfolio volatility by just under two thirds. In the tough financial year just concluded, our Balanced client portfolio’s had an average return of -2.5%. Feel free to reach out with any questions you may have re diversification and if you’d like to hear more about Providence.
*Providence’s Head of Investment Strategy, Will Porter discusses this in more detail https://www.livewiremarkets.com/wires/beware-your-correlations-in-a-multi-asset-portfolio
Justine Morton is a Senior Investment Adviser with Providence Wealth Advisory Group who has more than 25 years of experience in domestic and international markets.