While some commentators are talking about the current global credit crisis in the context of a one-in-100-year event, investors should remember that this does not mean that the portfolio diversification argument is dead.
If anything, during periods of severe market dislocation the discipline of portfolio diversification may well be your saviour, but only if it has been correctly executed.
The danger is becoming a victim of portfolio diversification “window dressing” which comes undone when it is most needed. Unfortunately, by the time an investor reacts to rectify a portfolio imbalance the damage is already done. While some asset classes appear to complement one another from a correlation perspective over long time horizons, such analysis can “wash out” the important question, which is, will this hold true when the wave of negative sentiment hits? Most investors are looking for a portion of their portfolio to hold their capital value and produce positive income at a time when falling equity markets and downward revaluations on property are often dragging these investments lower.
A thought-provoking source on this issue is Bridgewater Associates, a Connecticut-based firm founded 33 years ago and now managing A$189 billion. Through its All Weather strategy, Bridgewater advocates the power of diversification by “leverage adjusting” the expected excess returns from each asset class to balance investor risks (and not investor capital) across different economic environments.
Bridgewater believes the key long-term fundamental economic drivers are present in each of four environments – including rising growth, rising inflation, falling growth and falling inflation – and, as such, allocates 25 per cent of portfolio risk to each. For example, the rising inflation portion of the portfolio is commodities, inflation-linked bonds and emerging market debt spreads.
Bridgewater’s analysis shows that a conventional dollar-weighted portfolio comprising approximately 60 per cent equities exposure (including global, domestic and private equities), is in fact carrying 80-85 per cent of their risk budget in equities, after taking into consideration the cross correlations of asset classes. Furthermore its analysis of a conventional portfolio over the period 1970 – 2008 found that it was 97 per cent correlated with the equity component of its portfolio.
As many investors have found following the global credit crisis fall out, carrying excessive equity risk in a portfolio can be a dangerous strategy, particularly when equity markets retract with speed and momentum. For the weeks ending October 10, 2008 and October 24, 2008, the S&P/ASX 300 Accumulation Index and the MSCI World ex Australia Index plunged -15.8 per cent and -7.1 per cent respectively.
Another acclaimed investor worth mentioning on this topic is the portfolio manager of the Yale University Endowment Fund, David Swensen. While he may have a different view to Bridgewater on the merits of fixed income and commodities, he endorses broad portfolio diversification, but with a relatively heavy exposure to private equity and other illiquid asset classes, such as real estate and timber. In his book, titled Pioneering Portfolio Management, Swensen also emphasises the importance of regular portfolio rebalancing. This protects against portfolio asset class drift, which often occurs when investors become complacent during equity bull market conditions, as experienced over the period 2003 – 2007, where 15 per cent plus annual returns were posted for five consecutive calendar years.
So what asset class exposures would have offered some protection as part of a disciplined portfolio diversification process during the global equity market shock?
Three asset classes which offer excellent portfolio diversification and have posted double-digit returns over the past 12 months are gold, managed futures and inflation-linked bonds.
Gold
While gold offers a hedge against inflation and is regarded as a “safe haven” investment which performs well during equity market upheaval and economic uncertainty, the way in which this exposure is achieved is important.
Since the start of the global credit crisis, global gold equity indices such as the FTSE Gold Mines Index $A have tumbled as investors have sold equities across the board in their scramble for liquidity. During the same period, physical gold bullion has risen strongly. And while this has caused an extreme divergence between the physical metal and gold equities (not seen over the past 13 years), it highlights the point that to achieve a blend of uncorrelated asset classes you also need to consider whether the investment carries any cross correlation or covariance influences (a point highlighted earlier in the Bridgewater discussion).
So how do I invest in physical gold bullion?
In 2007 Gold Bullion Ltd (ASX Code: GOLD) listed on the Australian Stock Exchange as an exchange traded commodity, giving investors a relatively simple and easy way to invest in gold. GOLD is a structured redeemable preference share of nominal value which carries with it an entitlement to approximately one-tenth of one ounce of gold bullion. Investors will own a specific portion of a gold bar, not just the promise of a third party to pay gold, with the physical gold stored in the London vaults of HSBC Bank.
This investment has posted a return of 27.1 per cent over the 12 months ending October 31, 2008.
Managed Futures
Also referred to as CTAs (Commodity Trading Advisers), a managed futures investment is one which actively trades a portfolio of global futures, forwards and options contracts on commodities, currencies and financial assets. These investments are typically leveraged and apply rules-based, directional strategies. Fund managers investing in this asset class believe that market behaviour is not random and that statistically predictable movements can be identified and captured through the application of extensive research.
There are more than 150 futures markets traded globally across commodities, currencies, interest rates and equities. Just some of the contracts traded within these markets include crude oil, gold, silver, wheat, corn, cotton, coffee, British Pounds, US 10 year treasuries, the S&P 500 and the Japanese Nikkei.
Similar to gold, managed futures have exhibited the ability to generate positive returns during times of market crisis and have tended to be lowly correlated with other asset classes. For example, over the period June 1992 to April 2008 the Barclays CTA Index (hedged) had a -0.04 and a -0.15 correlation with the S&P / ASX 200 Accumulation Index and the MSCI World ($A) Index respectively.
So how do I invest in managed futures?
While still a relatively new type of investment, two funds which are readily available on a variety of administration platforms are the Winton Global Alpha Fund and the Select Futures Fund. These vehicles have posted returns of 17.25 per cent and 16.60 per cent respectively over the 12 months ending September 30, 2008.
Inflation-linked bonds
All bonds have two key components to their investment – principal (initial investment amount) and a coupon (interest payments paid over the life of the bond). For conventional government bonds, the principal paid at maturity remains unchanged but for an inflation-linked bond the principal is indexed to inflation. As the principal rises with inflation, the subsequent coupon payments are adjusted to reflect this change.
While inflation-linked bonds are expected to underperform conventional government bonds in disinflationary environments, they are expected to outperform during periods of inflation. This can often occur during the latter stages of equity bull markets as the economy overheats. More often than not, rising inflation will be accompanied by an increase in real yields (not currently occurring in Australia!) and this will lead to capital losses for both conventional and inflation-linked bondholders. Where the difference lies, however, is that the former will take the “full hit” of rising inflation and real rates while the latter will be able to avoid inflation losses while still suffering in nominal terms due to an increase in real rates.
Inflation-linked bonds exhibit some useful risk-return and diversification properties given their returns tend to be less volatile than conventional government bonds and have low correlation with traditional asset classes.
So how do I invest in inflation-linked bonds?
While these investments are only offered by a small number of domestic Australian fixed interest fund managers, two vehicles available include the UBS Inflation Linked Bond Fund and the Credit Suisse Inflation Linked Bond Fund. These vehicles have posted returns of 10.66 per cent and 10.05 per cent respectively over the 12 months ending September 30, 2008.
The key message is that diversification works and while there weren’t many places to hide as a lack of confidence gripped equity markets globally, an investment in truly uncorrelated asset classes will pay handsome dividends when navigating the inevitable stage of a market cycle where complete upheaval is present.
