Special Report written by LGT Crestone Senior Portfolio Manager Stan Shamu and Deputy Chief Investment Officer Kevin Wan Lum.
A summary of the key points:
In recent years, we aimed to position portfolios with the intention of protecting against a stressed market environment. Over this time, we emphasised building more robust portfolios that were diversified across asset classes and funds, and not overly exposed to any style or theme. In essence, it was not a market environment to ‘take big bets. These philosophies remain relevant, particularly given we are yet to gain clarity on how deep or long this downturn may be.
To briefly re-emphasis 5 key themes of portfolio strategy:
In the first instance, maintaining a disciplined approach to rebalance portfolios back to Strategic (SAA) or Tactical Asset allocation (TAA) weights has been shown to serve investors well to ensure that portfolios are fully invested and take away the emotion of deciding if and/or when to buy. There will be asset classes that have outperformed and may need trimming. Conversely, there will be asset classes that have underperformed may now be underweight and need to be added to. To refer to the time (pun intended) and tested investment adage ‘it's not about timing the market, but about time in the market’. Trying to time markets is challenging and as we have often observed, it’s ‘darkest just before the dawn’. Therefore, rebalancing takes the guess work out of investing and ensures we stay the course with our long-term strategy and objectives. Failure to rebalance can threaten the diversification benefits of a portfolio.
It is best practice to set limits or ranges around how far the actual asset allocation can drift from the target asset allocation (i.e. tolerance levels).
There are two layers to this aspect:
In risk-off environments, portfolios tend to be overweight cash, bonds and alternatives, while underweight equities and credit. Bonds have outperformed equities by over 9% over the last 3 months. For portfolios that receive distributions and keep them as a cash allocation, rebalancing is a more straightforward exercise as there is dry powder to allocate as required. However, in accumulation portfolios where distributions are reinvested, rebalancing is more involved. One of the primary reasons we hold fixed income is for the liquidity it can provide in stressed environments. Assuming they will be fixed income funds that are at the top of their ranges then this provides liquidity for a staged approach to rebalancing equities. The following section highlights the key focus areas when rebalancing within asset classes.
We are currently overweight equities. Notably, the current positioning for your client portfolios relative to target weight will be critical to the required level of rebalancing. A stepped approach to rebalancing would be sensible given the level of volatility we are experiencing and the degree of uncertainty. This is because an aggressive full rebalance exhausts ‘dry powder’ at a time when there could be more downside on the way. For incremental exposure, we want to ensure we maintain diversification across regions, market cap and styles so it should be targeted to areas where the portfolio is currently lacking. Similar to how we recommended trimming growth exposures when they were rallying, also consider trimming value type exposures that may have outperformed over the past 3 months. For context, the value factor is up 2% whilst growth is down 12% over the past three months.
The role of alternatives is to provide an uncorrelated/diversifying exposure to bond and equity markets— a role we feel will continue to be pivotal going forward. While the asset class will appear to be overweight at this point for those fully invested, maintaining an SAA weight allocation to this asset class is valuable in this environment. For incremental exposure, the focus should be on allocating to diversifiers and hedge funds which benefit from increased dispersion as well as infrastructure which we feel could be a beneficiary from several of the themes at play.
Portfolios should have adequate exposure to high-grade bonds as a core defensive allocation, complemented by ample exposure to high quality credit for more attractive risk-adjusted returns. Incremental exposure to the asset class should be to funds that focus on higher quality sovereigns and investment grade corporate credit with a focus on high current income. Funds that can generate reasonable income levels with a capital preservation focus should be a priority. Within credit, active management is paramount as credit selection, corporate liquidity and business prospects will be differentiators. When trimming, above target allocations that are liquid are an ideal source of liquidity.
While recent years have presented some challenges, active management is likely to be best suited to an investment universe where idiosyncratic risk and the cost of information is high. Active management tends to outperform in high dispersion markets where security correlation is low. The current stress on businesses, their operating models and balance sheets means there will be several 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 going forward.
Quality as 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 we have historically seen divergence between quality stocks and the broader index increase.
A falling Australian dollar has been a key part to global equities’ outperformance on an unhedged basis. Holding unhedged global equities exposure has also provided a level of diversification from a risk perspective. Having said that, at below 60 US cents, the argument to hedge some of the exposure is extremely compelling. Consequently, incremental exposure to international equities should consider a level of hedging.
As long-term investors, time in the market consistently proves more effective than trying to time the market. Trying to pick the tops and bottoms is incredibly difficult, often leading to missed opportunities. By maintaining investment discipline and staying invested through the cycle, you allow the power of compounding and the long-term strength of your diversified portfolio to work for you.
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