Investing without certainty
Will Greece, Spain or Italy crash out of the Eurozone? What happens to the oil price if there’s a military strike on Iran? Is the slowdown in China just a temporary dip, or the start of a long slump?
Given topical questions such as these, it’s no surprise that today’s investment outlook is often described as highly uncertain. Understandably, trustees are concerned about where to invest their funds to ensure that their capital is protected, as well as having the best opportunity to grow over the long term.
Yet this uncertainty is not peculiar to 2012, or to an era of high debts and austerity: it’s a permanent feature of the financial markets. We never have perfect foresight. The future is inherently unpredictable. Too much confidence in forecasting is often a recipe for financial pain.
As Nobel laureate in economics (1972) Kenneth Arrow has warned, our knowledge of the way things work ‘comes trailing clouds of vagueness’, adding that ‘vast ills’ often follow a belief in certainty.
Recognising the limits of our knowledge about the future is essential to any investment approach that seeks to deliver real capital preservation and growth. In managing assets for clients, you devote a great deal of energy to dealing with this uncertainty and avoiding vast ills.
There are several ways you can approach uncertainty, the most important being diversification. At its simplest, this involves little more than not putting all your eggs in one basket; in reality, true diversification is much easier to talk about than to achieve.
Diversification is an age-old concept, but it was given little formal attention until 1952, when American economist Harry Markowitz published an article that sought to demonstrate that it was possible to improve the balance between risk and return in an investment portfolio.
His key insight was that the volatility of a portfolio will be less than the sum of its parts, provided that, like the tosses of a coin, the heads on some throws counterbalance the tails on others.
Markowitz took this a step further, showing that by combining assets with different characteristics, it is possible to construct an ‘efficient portfolio’ that will yield the highest level of return for each level of risk. By changing the mix of assets, investors could move to a more ‘optimal’ portfolio, reducing risk without necessarily reducing return. This led some to call diversification the only free lunch in the investment world.
Based on the assumption that equities and bonds have different characteristics from each other, and their returns a low or negative correlation, traditionally diversified portfolios have been divided between these two asset classes.
A portfolio invested 60 per cent in US equities and 40 per cent in US bonds (rebalanced annually) has returned 3.8 per cent a year since 1900*. While below the 4.7 per cent annual return from a portfolio invested solely in equities, the combined equity and bond portfolio has only around half the volatility. However, while the returns of this traditional portfolio over the long term are solid, this hides considerable variations.
Most of the returns were generated in just four decades – the 1920s, 1950s, 1980s and 1990s. In these periods, annual returns averaged 11.3 per cent, compared with just 0.7 per cent for the other periods. What’s more, when rolling ten-year intervals were analysed, real returns were actually negative nearly a quarter of the time. For most investors, a decade of negative after-inflation returns is a lot to endure.
This 60/40 portfolio also went through periods of heavy losses, with long and deep drawdowns. Between a peak in 1968 and the subsequent trough in 1982, the portfolio fell in value by 36 per cent.
In times of high inflation, returns were particularly bad (in real terms). Bond and equity prices often fell in tandem, showing that there was no true diversification. In short, the approach fails because it assumes that equities and bonds always perform differently from each other. History shows that the correlation may be low and stable for long periods, but can and does break down, including at times when investors are most relying on it to hold.
This approach also neglects the importance of starting valuations and the economic backdrop. A particularly lethal situation, and one that concerns us today, is expensive starting valuations followed by a period of high inflation.
Inspired by Yale
In search of better diversification, many investors have embraced a wider range of asset classes, particularly alternative areas such as hedge funds, private equity, commodities and real estate. This approach, known as the Endowment Model, was popularised by David Swensen at Yale University and has been widely emulated.
On paper, an endowment-inspired portfolio appears well diversified. Securities are held from across global markets, with pie charts showing investments spread among six, seven or more asset classes. In each asset class, allocations are further diversified between multiple sub-sectors or regions.
Yet at a time of crisis, the pie charts would be better split into just two segments – one for securities that are correlated to equity markets, and one for those that are not. At the height of the financial crisis in 2008 and 2009, it became clear that many of the alternative assets were not alternative at all, but actually equity risk repackaged in a different form.
Compounding the problem during the credit crunch, many of the underlying investment strategies were relying on leverage, using borrowing to enhance returns. When panic hit the banking sector, and liquidity dried up, a downward spiral set in: the withdrawal of liquidity led to the forced selling of assets, which pushed asset prices lower, which led to more liquidity being withdrawn, triggering another round of forced selling. Seemingly diversified assets were in fact exposed to the same ‘risk factor’, namely a drying-up of liquidity.
In the year to June 2009, the Yale endowment lost 24.6 per cent of its value, or USD5.6 billion. The endowment at Stanford lost 25.9 per cent, while the endowment at Harvard lost 27.3 per cent. All three institutions blamed a failure of diversification.
Substance over form
What lessons do we take from the failings of the traditional and endowment approaches to diversification? First and foremost, that substance is more important than form. For example, just focusing on broad diversification across different asset classes is superficial. On the one hand, the performance between two asset classes – such as equities and commodities – may prove to be highly correlated. On the other, the performance within an asset class can be extremely varied: shares in a utility company and a gold mine, or Diageo and Lloyds, often perform very differently from each other.
Second, correlations are not stable. Instead, they are highly dependent on the prevailing market environment. An investment that might be considered a diversifier in a slowly rising market may offer little diversification during a crash, just when investors need it most.
Third, it is important to consider how a particular market regime might change, and how that would affect the individual securities in a portfolio, as well as the portfolio as a whole. This could involve analysing what might happen in an environment of deflation, high inflation or tightening liquidity.
Seeking real diversification
In managing investments we need to build on these lessons. Rather than think in rigid asset-class categories, we can make a formal distinction between two types of investment: return and diversifying assets.
Return assets are those we expect to produce capital growth over the long term. This includes all the securities and funds we would expect to be correlated to equity markets, albeit to varying degrees.
As well as equities themselves, assets in this category could include some hedge funds, property, corporate bonds and commodities. By contrast, diversifying assets are those we hold to offset risks and reduce volatility. We expect them to display little correlation to equity markets, even in extreme conditions. Historically, leading government bonds would have played a central role as diversifiers, but we believe they are currently overvalued, with yields that offer little compensation for the risk of underperformance in an environment of rising inflation. We are therefore working hard to find investments that will bring real diversification and offer us protection against falling equity markets, a surge in inflation, or a drop in the value of sterling.
Current examples include inflation-linked bonds, gold and bonds issued in hard currencies, such as Norwegian krone and the Singapore dollar. We also put some hedge funds in this category.
Finally, we hold a put option on the Australian dollar, a currency that tends to suffer at times when investors are selling risky assets, and which we believe looks overvalued. When the Australian dollar falls against the US dollar, the price of this option rises. As such, we see the option as an insurance policy that we expect to pay off in the event of a sharp fall in equity or commodity markets.
Uncertainty is a permanent feature of financial markets, making good diversification essential.
Aim to avoid the pitfalls of the traditional and endowment approaches to diversification by looking beyond simple asset-class categories to see the real characteristics of the investments you hold.
In doing so, we believe you can develop an investment approach that will deliver strong investment returns over the market cycle.
* ‘Third Generation Asset Allocation,’ by Brad Jones, Deutsche Bank
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