Edition: October / December 2016
A more intelligent way
Marius Oberholzer, Head of Absolute Return at STANLIB, rethinks portfolio diversification.
”The best way to control risk is to diversify, but we need to do it more intelligently,” argued Windham Capital president Mark Kritzman in a Financial Analysts Journal article Post-Crisis Investment Management. But how?
In SA most investors use asset allocation as the primary way to manage risk. An investorís allocation to equities, bonds, property and cash (and offshore) goes towards determining their low, medium or high-risk investor profile. However, the global financial crisis made it clear that diversification across asset classes alone is no longer sufficient for mitigating investment risk Ė especially over the short term.
The theory behind asset-class diversification stems from the idea that asset classes are affected by different macro-economic drivers. They respond to these drivers in different ways at different times. In other words, the main asset classes are uncorrelated, or at least have a low correlation to one another over the medium to long term.
When investors diversify their portfolios across asset classes they are looking for a balance of good returns from growth assets (equities) with portfolio protection (bonds or property) when growth assets perform poorly. Itís the classic ”donít put all your eggs in one basket” concept.
As we have seen over the past two decades, global markets have not been kind to investors. In an effort to adjust to a new investment environment -- where quantitative easing is a mainstay, interest rates are close to zero in global markets for five years or more, and where the search for yield is increasingly difficult -- fund managers and private investors are seeking new ways of mitigating, managing and embracing portfolio risks.
They involve breaking down equity risk, bond risk, property risk, cash risk and even offshore risk; then looking at their sub-components for a better understanding of the risks carried in a portfolio.
What are the real risks, where do they lie, and do how they behave during normal bull and bear market cycles, as well as during times of extreme stress? You have to understand the granular risks within asset classes and search for the small areas of risk-premia that are mispriced and could become a source of returns, diversification or downside risk protection.
So whatís the solution?
It lies in how risk is understood, measured and managed in a portfolio. This comes down to the type of fund manager an investor chooses and how adaptive that manager can be when risks, or even the perception of risks, change.
Country risk, for example, can affect an investorís equity, property as well as fixed income exposures in positive or negative ways. A large proportion of the SA property and equity market comprises counters with a high degree of offshore exposure. As the rand weakened through 2015, SA equities held up surprisingly well. For the most part, this was due to investors having a large proportion of their allowable exposure invested in direct offshore assets, as well as exposure to rand-hedge stocks through the JSE.
Investors need to ensure that their fund manager is thinking about risks at a granular level and planning scenarios for how and when certain risk premia will impact a portfolio positively or negatively.
STANLIB Absolute Returnsí thinking about asset classes is that they are simply neat labels. In our portfolio construction process, we seek to break down each asset class into its component parts in attempting to isolate the embedded risks (or real drivers of returns).
We believe this is becoming increasingly important given the extreme nature of valuations within some asset classes. However, we also believe that this approach is not a panacea to all portfolio risk. The important aspect is to be flexible, to consistently define and redefine risk, and to respond accordingly.
STANLIB is an authorised financial services provider.