Asset class trends and the need for diversification
January is typically a month when portfolio managers and advisers have their heads down completing year-end reviews and providing thoughts for the year ahead.
- The challenging local environment is likely to remain. Globally financial markets continue to become increasingly interconnected in nature.
- Sustainability issues are rapidly gaining a greater profile in the investment world.
- Investors need to be more precise and imaginative in considering how to deliver attractive risk adjusted returns.
- When constructing long-term portfolios, consider greater asset class diversification to capture the anticipated risk asset returns without the present heavy specific risk to equities.
- Visit STANLIB’s News & Insights page for more articles.
Looking back, looking forward
As we start a new decade, perhaps now is an appropriate time to raise our heads and assess some of the influences on long-term financial market expectations and trends. This is no easy task with the underlying fluidity of the financial services industry, the economy, and politics in South Africa.
Asset allocators in South Africa have generally marked the end of 2019 with a sigh of relief. Despite the absence of corporate profit growth, a challenging macroeconomic backdrop and an exceptionally difficult political environment, financial markets have typically performed well. In particular, the rebound in South African equities has provided some respite to balanced funds after a number of years of tough returns.
However, with this return being driven more or less entirely by a liquidity-induced re-rating, rather than underlying profit growth, the risk is that this rebound in equities is temporary.
Such a concern should focus allocators’ minds onto longer-term trends and how to prosper within them.
As we look forward, the challenges facing the country are unlikely to dissipate. Without substantial reforms, economic growth will remain muted, creating a headwind to corporate profit growth and the ability to address a bulging fiscus. In such an environment, investors will need to be more precise and imaginative in considering how to deliver attractive risk-adjusted returns. Within the balanced fund environment, South African funds have historically relied very heavily on a relatively small number of asset classes to drive expected returns; the considerable dominance of equities in such accounts has been a noticeable feature for a number of years.
Over the very long term, this approach has worked exceptionally well as the extended bull market in equities ensured strong absolute returns for investors, despite the risks associated with such asset class concentration.
More recently, that dependence on equity returns has been a challenge for the balanced fund industry after several years of poor returns from South African equities. As mentioned, last year broke that sequence as equities delivered a decent positive return driven entirely by a liquidity driven re-rating rather than corporate profit growth. Unless we believe that an extended South African equity bull market is back in town, which we would struggle to support considering the economic and political backdrop, then there is investment logic in considering greater asset class diversification.
True diversification should allow investors to capture the anticipated risk asset returns without the present heavy specific risk to equities. Implementing that diversification can come from two areas.
Firstly, investors should intelligently utilise the opportunities available from the overseas exposure allowed in portfolios. Secondly, both in South Africa and internationally, funds can incorporate a broader number of asset classes to minimise specific asset class risks. This can include relatively vanilla asset class areas but it can also incorporate alternative assets like infrastructure and private credit. This can increase the diversification without necessarily challenging the overall expected returns. The academic logic for such an approach is compelling.
True diversification should also allow investors to deliver lower volatility of returns and more precise risk budgeting within their portfolios. This has been very evident in the international investment environment; after the carnage of the global financial crisis there has been substantial growth in multi-strategy funds that have delivered impressive risk-adjusted (and absolute) returns for clients.
Another trend for the next decade will undoubtedly be the continued interconnected nature of global financial markets. In some ways this has been a saviour for South Africa over the last year. After more than 10 years of global quantitative easing, the liquidity created in the financial system has been substantial, dragging down the yield on risk-free assets and this capital has consistently struggled to find attractive financial returns.
This excess flow of capital typically needs to be deployed in open and credible international markets, and South Africa continues to retain that tag despite the economic and political challenges.
If liquidity remains strong in the short term, then it may allow the financial markets in the country to absorb the traumatic prospect of the final rating agency moving South Africa to junk status. However, within this continued interconnected world, the next decade will hold some portfolio construction challenges if that liquidity trend reverses.
Once again, diversification and precise risk budgeting will be critical to truly control overall risk in portfolios in such an environment.
Finally, the next decade will bring about an increased focus on sustainability-related issues for corporates and investment managers. Environmental, social and governance (ESG) issues will have a higher profile in the investment world. This is already occurring in international markets and is rapidly developing as an important issue in the South African investment community.
The investment world is always fluid and successful asset managers/advisers need to be able to adapt. Facing up to the reality of change and designing products that are genuinely focused on clients’ future expectations, rather than something anchored in history, will be crucial.
A progressive and intelligent mindset will be important and this should allow investors to address the challenges on the front foot to ensure decent financial returns.