What’s in a durable portfolio?

26 June 2020

It has been a trying time to say the least as the COVID-19 pandemic has pummelled markets leading to investors panicking about how hard their portfolios have been hit. 

The portfolios that have been able to withstand the blows of pandemic have focused on durability. 

While diversification is an obvious feature of any durable portfolio there are a number of other aspects financial advisers should look for when choosing funds from an approved product list (APL) or when building a portfolio. 

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One of the biggest differences with the current recession and market downturn compared with previous ones is the fact that this stemmed from a health crisis, rather than a financial crisis.

Investment strategies have been challenged and picking the right manager that matches client risk has been a huge factor in durability success.

MANAGER QUALITIES

Mercer’s wealth management leader for the Pacific, Luke Fitzgerald, told Money Management that advisers need to look for managers that are able to pull multiple levers in a cycle. 

“You’ve got to look at whether the manager’s design or portfolio’s mandate allows them to pull multiple levers through a cycle. Wealth management clients can’t be swapping and changing managers on a three or six monthly and or even on a yearly basis due to operational constraints so you need to let managers have enough breadth of opportunity to make decisions for clients,” he said.

“Advisers also need to look at how they construct their asset classes and types of managers. If you have an unconstrainted type manager in a portfolio who can take bigger bets then you have to mitigate that risk with other managers that may have a bit more static risk analysis. The end game is achieving quality managers for each asset class to beat a particular benchmark whether it is an up or down market.”

Fitzgerald said advisers should look for managers with portfolios that were “suspiciously robust” but that they needed to understand what the robustness meant and what was sacrificed to achieve that.

“They should really be building and looking at portfolios that are appropriate for client’s risk tolerance. The more you constrain the portfolios and managers the more levers you take off the table and that can be an issue,” he said.

“That said, you do want managers and people working with you to have that depth of experience and knowledge to apply those levers appropriately.

“Advisers should not just look at past history, as they must also understand forward-looking views and idea generation. They don’t want to be turning portfolios over during certain times just because they’re not performing as they will miss the upside when it comes around.”

ClearView chief investment officer, Justin McLaughlin, said advisers needed to remember that fund managers were not asked to manage the adviser’s risk but instead were asked to add value over time and to beat the market by a percent or two.

“You have to be aware of what you’re asking them to do. It’s very much understanding what a manager’s investment mandate permits them to do. If a fund manager does not manage market risk it just might not be a task that they have set or a function they have been asked to perform,” he said.

“If you put together the portfolio, fundamentally you decide what you have in growth assets and this determines the amount of risk you have. You have to work out who is the right fund manager for you and it’s about picking the right style if you want risk managed.”

McLaughlin agreed with Fitzgerald that managers needed to be assessed over a reasonably long period and that it was important they answered whether they performed in line with the style they said they would follow. 

On long-term assessments of managers, Zenith chief executive, David Wright, said there was no better time to be assessing managers than in times of stress. 

He noted that while advisers needed to focus on the team and personnel through many market cycles, fixed income managers had not experienced a bear market in 20 years.

He warned that managers that were not moving towards greater environmental, social, and governance (ESG) practices would get left behind.

“The ‘G’ aspect is well and truly developed but it’s the environmental and social aspects that are still developing for managers and it’s really becoming mainstream,” he said.
Wright said that while diversification across asset classes and geographies was important, a diversification across manager styles was also needed to make portfolios durable.

However, he said there was a temptation to move out of portfolios when managers underperformed and said there would always be periods where managers in certain styles underperformed.

INVESTMENT COMMITTEE ADVICE

Alternatives

Wright said that as active funds historically provided better protection in downward markets over passive and index funds Zenith had encouraged some switching, especially in the Australian real estate investment trust (AREIT) sector.

“AREITs have been hammered recently as a result of some retailers closing, going out of business, and property and office building owners seeking rent, or dealing with rental reductions,” he said.

“A lot of people had said that active ARIET managers had not outperformed in recent years so the exposure they had was through an index and this was quite retail heavy.”
He said active AREIT managers had more flexibility to navigate around the different property sectors and those that had been hardest hit.

“You have managers that are long-short flagship types like Platinum and Antipodes. They’re also going to struggle in a period when markets are rising and their market exposure is lower than 100% because they use shorting,” Wright said.

“Through that late February/March period where the market tanked those managers performed really well. 

“This has highlighted that there is a place for long/short market neutral like alternative strategies that hadn’t enjoyed a period of performance, and never do in raging bull market conditions, but now has provided people returns and protection in downward markets.”

Wright noted that Australian microcaps had been useful during the downturn as medium-sized companies had performed better but that many investors did not hold microcap exposure due to volatility and liquidity concerns.

Alternatives were another asset class that Wright said was not allocated towards as much to as many advisers and investors did not understand alternatives.

“I’d like to see more advisers and portfolios using alternative strategies like managed futures and global macro. As an industry we are not as exposed to alternative strategies as what we should be and they will be really useful going forward with market volatility and geopolitical uncertainty,” he said.

Hedging

For McLaughlin, ClearView had been advising for currency hedging in portfolios as the Australian dollar tended to be quite correlated with risk. 

He said the Australian dollar tended to fall when risk rose and tended to rise when risk fell and the falling dollar partially offset the falls in offshore assets. 

“Being unhedged is a good risk mitigant for most investment portfolios so the hedging strategy is quite important because most portfolios probably have at least as much offshore as they do onshore at least in terms of equity exposure,” McLaughlin said.

“Another approach would be to try and invest in fund managers who are trying to manage directional risk – long/short managers as they can hedge market risk directly. Some had a tough time in the last few years but they’ve generally outperformed when markets haven fallen so there are a number of well-known managers that fall into that category. 

“There are managers that also try to explicitly manage market risk as part in parcel of their core philosophy. So advisers should allocate at least partially to a long/short manager or to a manager that is consciously trying to manage market risk.”

McLaughlin noted that prior to the downturn he was defensively positioned with investments in cash and fixed income and then halved that defensive position during March and April to take advantage of the market dip in equities.

“So far that has worked as markets have rallied,” he said.

“We think there will be further volatility between now and November. So, we think we’ll get further opportunities to take back some of the risk mitigate strategies we have in place.

Value versus growth

McLaughlin noted that he would not have too much exposure to American growth companies as while they were good quality they were expensive and their performance might be unsustainable.

“A lot of the time when you go into a big correction and subsequent rallies the stocks that sell off the most are the very expensive tech stocks, which is what happened in 2000, and fall the furthest. 

“What we’ve seen in the last little while is the big American tech companies being the best performers on the way up because they were growing but also quite defensive on the downside,” he said.

“Whether that’s sustainable, that’s debateable but that’s an unusual characteristic in the sense that the best growth stocks have been the best defensive stocks as well.”

For Wright, value investment styles still had a place in portfolios despite not performing well for some time.

“Recently, some managers that did best that had a growth investment style and that’s tended to lend itself to large US tech names and that’s still valid and legitimate,” he said.

“But value investment style base in Australian and global equities hasn’t done well for quite a period of time and we’ve had people say ‘in a market correction, isn’t value meant to protect us? Should we get out of value?’ The answer is no. 

“Because if you look back over history, when you get over that first market shock and indiscriminate selling no styles work very well when people are try to liquidate holdings.”

He said in the shorter-to-medium term the value investment style had protected and generated better investment returns in market pulldown periods than some of the other investment styles. 

“The messaging has been around ensuring you have diversification across not just asset class and geographies but also manager investment styles,” he said. 




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