Diversify beyond traditional ideas in a volatile new normal

Investors can no longer rely on traditional sources of diversification such as allocating money between bonds and equities or developed and emerging markets, to protect them in a more fragmented world with volatile markets, speakers warned at the Institute of Retirement Funds Africa (IRFA) and the Morningstar Investment conferences held in Cape Town.

Both conferences heard how global changes challenge long-standing investment assumptions. The long period of falling inflation, declining bond yields, globalisation, cheap capital and geopolitical stability has lifted most assets in the past. But it has given way to a world of more volatile inflation, higher government debt, protectionism, geopolitical rivalry, technological disruption and highly concentrated markets, Mario Fisher, chief investment officer for systematic strategies at Momentum Asset Management, told the IRFA conference.

Fisher said the assumptions behind asset allocation decisions in many investments need to be reassessed.

The world today

Today governments are intervening directly in economic policy to prioritise resilience, geopolitical competition is influencing how capital is being allocated, companies are duplicating supply chains to move production closer to markets and technology is creating unprecedented levels of disruption, he said.

The result is higher costs and inflation which increases market volatility.  Investors should expect political decisions to increasingly influence investment outcomes, Fisher said.

Increased market volatility

At the Morningstar conference’s multi-asset panel, Rehana Khan, co-head of SA equity and multi asset at Ninety One, said the world is in the late stage of a cycle of US dominance. The US is trying to hold on to its superpower, while China is trying to take it away.

The argy-bargy between them is going to continue and left-of-field events will occur all the time, she said.

In addition, the rise of populism in many countries, increasing protectionism and deglobalisation are causing volatility, she said.

Volatility may be scary but it creates opportunities as companies need to change and this creates winners and losers, Khan said. Active managers can evaluate the opportunities and find true winners and losers within sectors across various areas of financial markets.

Investment portfolios need to be managed effectively to navigate market volatility while still making good money for investors, Khan said.

Looking beyond asset classes

Fisher said fund managers have a far broader universe of assets and opportunity sets to explore, but it comes with a degree of risk.

Different asset classes can be exposed to the same risk at the same time, resulting in all returns diminishing at the same time, so managers need to carefully consider what drives returns, he said.

That view was echoed at the Morningstar conference panel, where Justin Floor, head of equities at PSG, said asset classes had become “a little bit less useful” as market indices had become highly concentrated and correlations between asset classes were less stable.

In a world in which bonds and equities can move together, simply combining asset classes may not produce the defensive outcome investors expect, he said.

Floor said managers need to look beyond asset classes to understand the actual risks of any investment and how these risks aggregate in an investment portfolio. They should not try to avoid risk but rather identify and combine securities driven by different risks for a robust portfolio, he said.

Michael Dodd, director of manager selection services at Morningstar Investment Management, noted that the investment industry had written many obituaries for the traditional 60:40 multi-asset portfolio – 60 percent in equities and 40 percent in bonds – as it was no longer an effective way to diversify.

Khan said managers no longer wanted to hold developed markets’ government bonds because higher government debt burdens made them riskier. Bond yields may rise at precisely the moments investors hope bonds will protect portfolios, she said.

Consider investing in alternatives

Alternative asset classes featured strongly as a source of diversification in discussions at both conferences.

At the IRFA conference, Senzo Langa, chief investment officer at AlexForbes, argued that hedge funds, infrastructure investment, private equity and private credit had delivered useful risk-adjusted returns in recent years, often with lower volatility than bonds.

Khan said the global shift towards alternatives and portfolios split 50:30:20 between equities, bonds and alternatives partly reflected investors searching for substitutes for developed-market bonds.

But she cautioned that illiquidity of – or the inability to sell − alternative asset classes could be dangerous in a world shaped by AI, geopolitics and rapid change. The ability to change one’s mind has become increasingly important, she said.

AI and market concentration

Fisher said AI was transformational and historically periods of major technological innovation have created extraordinary opportunities for wealth creation.

But it also creates disruption and the challenge for investors is distinguishing between the providers, the adopters and the losers, he said.

Echoing this at the Morningstar conference, Khan said the impact of AI on securities should be viewed in three broad buckets:

• AI winners across sectors such as technology, industrials and energy;
  
  
• Possible AI losers, including some software and consulting businesses but not those with a competitive edge or moat who are using AI to improve the business; and
  
  
• AI-neutral areas such as healthcare, consumer staples, defence and insurance.

The task for portfolio managers was to distinguish between exuberance, genuine opportunities and areas that had become overbought or oversold, she said.

Craig Simpson, head of multi-asset portfolio management at M&G Investments, said it was difficult to know whether AI had become a bubble, but valuations were stretched in parts of the market and there was considerable enthusiasm around the theme.

Managers therefore needed to be able to capture some of the AI opportunity without being forced into the most expensive areas of financial markets, he said.

Market concentration risks

At the IRFA conference, Langa said that while global equities have been a stronger source of long-term return, local equities can outperform meaningfully over shorter periods, making it essential for investors to find a good balance.

The challenge with going offshore is that it no longer automatically delivers broad diversification. The US now dominates developed-market indices and there is a high exposure to the technology sector everywhere – developed markets, emerging markets and in Europe, he said.

The emerging market index is the most concentrated in the world, with Taiwan and South Korea playing a much larger role now that China’s weight has declined, Langa said.

He warned that investors buying global passively managed equity exposure were, in effect, buying significant exposure to the US, the Federal Reserve, US inflation, employment data and technology.

Expensive markets favour active managers

Sean Neethling, head of investments at Morningstar Investment Management, added to this at the Morningstar conference, saying when markets are cheaper you can invest in a passively managed index-tracking fund, enjoy exposure to the aggregate market at a really low cost and generally get a good outcome.

But when market indices are as concentrated as they are today, expensive companies become more expensive and represent bigger parts of the index. It then becomes highly unlikely that investors will get good outcomes by purely investing in passively managed index funds, he said.

Neethling said the value of active management is showcased when markets are concentrated and overpriced as active managers can allocate across different regions, sectors and styles.

Combining passive with active management gives investors the best opportunity to get good outcomes, he said.

Greater diversification

The common theme was that investors need diversification that goes beyond being invested across many holdings, asset classes or geographies.

The world that supported simple asset allocation rules has changed. Portfolios built for the next decade need to be more flexible and asset managers need to consider being more focussed on the sources of return and risk of each investment they hold.