Justin Floor | Defending your fund when what used to work no longer does
Cape Town - 2022 so far has been a tough market with most assets and asset classes losing value, sometimes brutally. Even the king of defensive asset classes, developed market government bonds, experienced deep and painful losses this year. This has resulted in one of the worst periods for global 60/40 ('balanced') portfolios in history.
Closer to home, it has also been tough with the average fund in the ASISA High Equity category losing -2.4% for the year to date until end October, and only 21% of the funds in the ASISA High Equity category managing to eke out a positive return (based on Morningstar data until 31 October 2022 and excluding funds of funds). Looking forward, uncertainties around global interest rates, growth, inflation and geopolitics remain elevated. In this context, what strategies and tools can investors use to play defence and hopefully protect capital when markets go through periods of unprecedented upheaval?
The traditional strategy would be to simply de-risk: sell equities and other growth assets and increase cash holdings. While this is sometimes sensible, it is worth noting that this choice confers significant timing risk and opportunity cost on the de-risking investor, which can materially impair the possibility of growing capital. This is especially true if available equity opportunities are very attractively priced. In general, we tend to think timing is very difficult to get right consistently, and instead try to approach this problem differently.
- Think unconventionally about what could provide capital protection in this environment. For example, energy and material companies that enjoy very supply-constrained markets and have high free cash flow yields (like portfolio holdings Shell and Glencore) have delivered strong positive real returns despite the weak economic outlook. Another example would be inflation-linked bonds which compensate investors for realised inflation over and above generous real yields. These opportunities (and others like them) have played a valuable defensive portfolio role, while traditionally defensive assets such as global bonds and expensive quality shares have struggled in this environment. Looking forward, we think gold and gold equities have the potential to play this defensive role as global interest rate normalisation approaches its peak.
- Intelligently hedge unwanted risk: elevated earnings levels and valuations make it likely that the global equity market (proxied by size-weighted indices) is overvalued and could deliver very poor returns to investors from this point forward. Therefore, we think it makes sense to use instruments such as put options on equity indices to reduce portfolio market risk (also known as beta), while remaining invested in our stock picks, which remain under-owned and attractively priced in comparison to the broader market.
- Be willing and able to pick stocks away from the benchmark: our best performers and contributors have been smaller stocks like HCI, Grindrod and global shipping companies which a broad-based index will not have exposure to. In a market of considerable top-down risk, we think thoughtful bottom-up stock picking can greatly moderate portfolio risk.
- Think carefully about correlations when constructing portfolios: diversification only reduces portfolio risk if the portfolio holdings are sufficiently different (or uncorrelated) to each other. We deliberately seek to elevate investment ideas with very different drivers and dynamics than other portfolio holdings with the overall portfolio balance in mind. A fully integrated global capability greatly assists with this.
- Finally, if you've done the above in a thoughtful way, don't get too negative: sometimes the best defence can be a good offence. Trust your research and convictions and take an appropriately long view: we are finding our best ideas increasingly have tailwinds while global markets are entering headwinds. In many cases share and bond prices have become more attractive as the market tries to process the global macro environment. Timing will be difficult and therefore we think it is wise to be positioned before the turn.
How well has this worked? We are pleased and encouraged that we've been able to both protect and grow our investors capital across our funds in what has been a very tough year, contributing to a healthy performance profile over all meaningful periods.
Painful price corrections and excessive levels of volatility is a good environment for sensible, unconstrained and active management of portfolios. Looking forward there is a lot we do not know, and a posture of humility and curiosity is as important as ever to successfully navigate the future. This, perhaps more than the others, is the essential ingredient of continued success.