A time when diversification meant 60/40
In the two decades leading up to 2020, the 60/40 balanced portfolio delivered solid returns. When bonds fell in value, equities did well and vice versa. Investors felt confident, akin to yachtsmen navigating calm seas with advanced navigation tools. This environment was characterised by low or declining interest rates, robust global trade, and trust in central bank policies—an era known as the great moderation. Despite disruptions like the global financial crisis of 2007/2008, the overall investment climate remained stable.
A dramatic shift in the investment landscape
The Covid-19 pandemic dramatically altered the investment climate. Investors now face increased volatility, not just in asset prices, but in correlations between assets and a shifting global order punctuated by geopolitics and geoeconomic policies. Inflation has surged, negatively impacting bond returns, while geopolitical risks have emerged from various fronts. Developments in artificial intelligence have added complexity, with potential negative effects still unfolding. A trade war between the US and several countries, including China, Mexico, Canada, and Europe, complicates traditional investment strategies even more.
Rethinking diversification
2022 was a pivotal year, just like 2008 when investors questioned illiquidity premiums, leverage and the notion of “as safe as houses”. This revealed vulnerabilities in supposedly diversified portfolios. Both equities and bonds sold off, as did credit. Rising bond yields reflected increased repayment risks due to government spending and the risk of higher inflation. The global bond market faces heightened geopolitical risks and geoeconomic policies influenced by party politics, particularly in the US.
Moreover, true global diversification is becoming increasingly challenging. The "Magnificent Seven" companies account for nearly 32% of S&P 500 index returns, while US equities represent about 73% of global equity indices. This concentration complicates genuine diversification efforts. Even these leading companies faced losses in 2022 due to recession fears.
Embracing flexibility in portfolio management
For South African investors, offshore investing is seen as a useful diversification tool, particularly when the rand is weakening. However, due to rand fluctuations, if you invest in a supposedly low-risk offshore investment, the asset becomes highly volatile if the currency effect isn’t also taken into consideration. Volatility in an offshore portfolio can be greater than a purely domestic mix of bonds, equities and cash. Since the volatility of the rand is so much higher than offshore assets, the volatility of those assets in rands becomes much higher from a South African investor’s perspective.
To achieve a better form of diversification from offshore assets, South African investors should consider hedging currency risks. Hedging the currency risk allows for more targeted investments. It not only improves the diversification benefit, opening a wide range of portfolio construction options, but has historically also enhanced returns.
In constructing a portfolio, investment managers must understand how assets work together and what risk controls need to be in place. Every asset management team has a unique approach. STANLIB’s Multi Asset team focuses on top-down rather than bottom-up investing, allowing for aggressive tilts in portfolios when we identify high-conviction opportunities.
Collision avoidance in investment management
Just as collision avoidance is critical for yachtsmen, it is equally important in investment management. The STANLIB Asset Management Multi Asset team actively seeks truly uncorrelated assets rather than those that merely appear to offer diversification. For instance, in seeking true diversification strategies, the SocGen Trend Index can protect a conventional 60/40 portfolio during market downturns, ultimately offering the portfolio a return stream that differs from more traditional, tactical and strategic positioning, enhancing the overall portfolio returns and risk.
While hedging and seeking uncorrelated strategies may incur costs, the potential risks of not doing so in a rapidly-evolving market can be far greater. Therefore, while the quality of individual assets is vital, understanding how they work together over time is essential for a much more active approach to successful portfolio construction.
Adapting to an evolving market
As we navigate this ever-changing investment landscape, much like yachtsmen adjusting their course, managers must remain open-minded and continuously assess the appropriateness of their asset allocation and strategy selection. The art and skill of being an investor is to recognise when the environment has changed, and when a strategy style or asset is no longer appropriate or has lost its shine. The quest for low-cost opportunities and truly uncorrelated assets, or finding managers that can derive alpha from them, is more critical than ever.
In this complex environment, while the future remains uncertain, our focus should be on maintaining the robustness of our strategies and adapting to the winds of change. By rethinking diversification and not being wedded to what has previously worked, we can better position ourselves for the potential storms and rougher seas ahead. DM
Author: Marius Oberholzer, Head of Multi-Asset