Five pillars supporting your portfolio strategy

Given the current volatile environment, it is prudent to maintain a well-diversified portfolio

The last couple of months have been extremely volatile to say the least, and this has naturally presented a lot of challenges for investors. Recent years have seen markets rise in an almost uninterrupted fashion with only a few bouts of significant volatility. This has, perhaps, led to some complacency among investors.

Having said that, periods of market stress also present opportunities as “dislocations” emerge. While markets globally seem to be in a bit of a holding pattern as investors contemplate their next move, now is the time for investors to reassess their strategy and position portfolios for the longer term, so they are protected against further volatility and capture the eventual recovery.

Essentially there are five pillars of portfolio strategy — rebalancing, diversification, emphasis on quality, active management and hedging.

1. Rebalancing takes the guess work out of investing

Asset allocation plays a key role in any diversified strategy and let’s reinforce the importance of rebalancing in an environment like this. Historically, market timing has invariably proved to be elusive so rebalancing ensures we stay the course with our long-term strategy and objectives.

It is best practice to set limits or ranges around how far the actual asset allocation can drift from the target asset allocation (that is, tolerance levels). There are two layers to this aspect, the first being the strategic asset allocation (SAA) ranges, which are generally hard limits and stipulate a wide range for the asset allocation. The second layer, which is more applicable in this environment, is around tactical asset allocation (TAA) ranges. Typically, this entails stipulating a maximum and minimum range the actual asset allocation can drift away from the TAA. In risk-off environments, portfolios tend to be overweight cash, bonds and alternatives, while underweight equities and credit.

2. Diversification plays a key role in strengthening portfolios

Given the current volatile environment, it is prudent to maintain a well-diversified portfolio that is not overly dependent upon a particular outcome, which would leave investors exposed to unpredictable risks. While we expect to eventually see a recovery, diversification will continue to play a key role in enhancing the robustness of portfolios.

Being prudent with asset allocation and having ample exposure to various funds across sub-asset classes and styles are the key components of diversification. Well diversified portfolios should yield better risk-adjusted returns over the long run.

3. Active management can provide downside protection

While recent years have presented challenges, active management is likely to be best suited to an investment universe where there is idiosyncratic risk and the cost of information is high. Active management tends to outperform in high dispersion markets where security correlation is low. At present, the stress on businesses, their operating models and balance sheets means there will be a number of pitfalls to avoid.

Active management is prudent to help manage these potential pitfalls and should be a key part of an investor’s portfolio strategy.

There is also a good opportunity just now to trim passive exposures to risky parts of the market, such as high-yield credit. Having said that, passive strategies can play a role in portfolios, particularly when used as a low-cost solution in more predictable parts of an asset class. In practice, this means potentially using an exchange-traded fund in equities.

This would then be complemented by active management in less predictable parts of the market. While this applies to equities, it is less applicable to alternatives and fixed income, where fund manager skill is expected to generate the majority of returns and credit risk has to be managed appropriately.

4. Quality is the key building block in today’s market

While quality is always an important part of any investment strategy, it is even more critical now. This aspect of portfolio strategy ties in with rebalancing, diversification and active management. Through stressed market conditions there has historically been a divergence between quality stocks and the broader index increase. This phenomenon is also evident in fixed-income markets where instruments from debt-laden sovereigns and companies are out of favour. In this environment, it is imperative to differentiate between assets that have solid fundamentals and those that have a real probability of capital loss — higher-quality credit is significantly outperforming lower-quality credit.

5. The benefits of hedging are compelling

A falling Australian dollar has been a key part to global equities’ outperformance on an unhedged basis. Holding unhedged global equities exposure also provides a level of diversification from a risk perspective. Having said that, at current levels, the argument to hedge some of the exposure is extremely compelling. For those investors who desire a level of hedging, determining a strategic hedge ratio is quite encompassing and generally requires a quantitative and qualitative assessment of their objectives. It’s best to have a flexible view of hedging, some research suggests an optimal static hedge is about 20-30 per cent of the Australian-domiciled global equities portfolio.

Stan Shamu is a portfolio strategist at Crestone Wealth Management.

www.crestone.com.au