Australian shares are up over 10 per cent over the past year, and their global counterparts have performed even better, with the MSCI and ACWI index up around 28 per cent over that period.
That’s according to Allan Gray investment specialist Chris Hestelow who points out that both markets are trading at a very significant premium compared to history across a number of valuation metrics.
“As investors, this is often where we feel safest,” Hestelow says.
“We have a tendency to extrapolate what has happened recently out into the future, so when times are good, we expect the good times to keep going. In fact, euphoric markets are actually the most dangerous times for investors.”
The temptation, he says, is to pile into areas that have already done well. The biggest risk is to overpay for assets and destroy capital in the process when prices fall.
To provide a counterbalance to potentially overvalued equity exposure, portfolios need to have defensive assets. Most multi-asset portfolios use fixed income securities, such as bonds, to achieve this.
Over the long term, equity markets and fixed income markets have been negatively correlated – such as when equity markets rise fixed income falls, and vice versa. Fixed income has done a good job of cushioning the impact of weaker equity markets, though less so in recent years, as movements between the two markets have become more closely correlated.
But fixed income is not without its own risks. If inflation proves to be more persistent than the broader market expects, and yields rise, bond prices may fall, Hestelow points out.
It makes sense to have significant diversification within an investor’s defensive assets.
“Some alternatives to classic bonds to help reduce market risk include hedging out equity market exposure,” Hestelow says.
“For example, one could sell futures against broad market indices. In doing so, the investor can maintain exposure in companies they find attractive, but reduce the negative impact to portfolios if there was to be a broad equity market sell-off.”
Holding gold can provide another level of diversification as an asset that can potentially help investors limit portfolio drawdowns during a market panic. This is because gold has little correlation with equity and bond markets and has historically outperformed during broad equity market selloffs.
Hestelow says that while you can buy gold bullion and hold it in a portfolio, this can be illiquid. Allan Gray prefers to get exposure via a gold exchange-traded fund which trades on an index like a share.
He adds that flexibility is critical in any multi-asset portfolio.
“Many traditional diversified managed funds have a rigid portfolio split 60/40 between growth and defensive assets, which limits the portfolio manager’s ability to increase exposure to defensive assets when growth assets are overpriced, and vice versa,” Hestelow says.
“We believe a much more optimal way to manage a portfolio is to have wide asset class ranges, allowing us to dial up and down exposure to different asset classes, depending on the opportunity set available. If there is absolutely no value on offer in a particular sector or asset class, one should not be compelled to have significant exposure to it.”
Morningstar chief investment officer Matt Wacher says that to achieve flexibility, investors can hold liquid defensive assets such as Australian bonds or even cash, which allows investors to quickly deploy capital should equity markets move to a more risk-off phase presenting opportunities for a valuation focused investor. Even better in the current environment is that bonds and cash are delivering yields that justify their position in a multi-asset portfolio again.
“Defensive assets such as government bonds at current yields are truly able to act as diversifiers again,” Wacher says.
“In a risk-off environment in equities bonds should do well, especially if economic growth is slowing. These assets really provide the ballast to a multi-asset portfolio and can even allow investors to take more risk in growth assets as they take comfort that they will get some reward from their areas of defence if things go awry.”
