22 August 2023
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As I find myself entrusted with writing the Weekly Digest, it feels much like a novice artist being handed a paintbrush for the first time. My aspiration is, while John Wyn-Evans is away, I manage not to smudge his creation.
An intriguing revelation to share might be that I never imagined ending up in the world of investments or anything connected to finance. I’ve always had a curious and creative mind, and during my youth, aspired to be a writer. Life had other plans though, and luckily, I’ve ended up building investment portfolios.
Like an artist may approach a blank canvas, portfolio construction can resemble the creative process of painting. By employing a palette of colours and arranging in different combinations with varying brushstrokes, artwork can be rendered distinct. Similarly, bringing together investments in a particular way can align with unique needs of clients.
Portfolio construction commences with defining goals and planning, as clients outline their financial aims and risk tolerance. The next step involves asset allocation, which is similar to a painter choosing a canvas and arranging elements for a well-balanced composition. Just as artists meticulously select colours, brushes, and techniques, portfolio managers opt for stocks and funds to capture specific themes or opportunities. Artists make refinements during painting, and portfolio managers may choose to re-organise portfolio holdings to deliver better risk-adjusted returns. Both must adapt to changing conditions – the artist to lighting and mood, and the portfolio manager to changing client circumstances and long-term market fundamentals. Lastly, just as an artist steps back to assess the overall painting, a portfolio is monitored and rebalanced so it effectively captures client needs throughout life’s journey.
Artists throughout history have pushed the boundaries of traditional artistic norms, leading to the emergence of new styles. From the Renaissance’s realistic representations to the abstract forms of modernism, artistic movements have evolved in response to changing societal values and innovative techniques. Similarly, investment theories have transitioned from simplistic heuristic rules to more nuanced strategies, incorporating factors like behavioural biases and technological advancements.
Back in 1952, Harold Markowitz, a recipient of the Nobel Prize, developed something called Modern Portfolio Theory, which for many years was the foundation of portfolio construction. This foundation comprised of 60% equity and 40% fixed income and was designed to provide investors with the highest possible return per unit of risk. Markowitz’s theory was a game-changer, revealing that the collective performance of a diversified portfolio had greater significance than the outcome of any single security. Despite initial doubts, the 60-40 portfolio’s ability to produce a smoother investment experience compared to an all equity counterpart stood the test of time. Not only was this method of building portfolios elegantly simple, but it also yielded favourable risk adjusted returns.
By now, it’s well known that 2022 presented challenges for investors, particularly for those with diverse portfolios involving stocks and bonds. Central bank actions have caused unusual dynamics in capital markets, revealing the 60/40 allocation is no longer aligned with modern market conditions. Unlike the typical inverse correlation, where stocks and bonds usually move in opposite directions during market stress, this pattern didn’t hold true in 2022. As humans, we often stick with what’s familiar instead of reconsidering and adjusting to new situations. It might be wise to view theories as formulated for “the long run, but not for the indefinite long run” (Harry Markowitz).
It’s important not to adopt the approach of “once done, leave it unchecked”, while also avoiding allocation changes due to market noise. Negative returns from both equity and bonds are generally rare occurrences. Moreover, steep inflation and historic rate hikes are in part a consequence of the pandemic, a rare global outbreak. Indeed, the dramatic reset last year is allowing diverse portfolios to be constructed with a higher allocation of fixed income, a prospect not seen in years. Higher yields enhances bonds usefulness within a 60/40 portfolio, providing a more substantial buffer against potential equity losses.
Most of our client portfolios won’t follow a 60/40 structure, this precise allocation may not suit financial circumstances. Additionally, the investment universe is much broader than just stocks and bonds. Our multi-asset portfolios also include other asset exposures like alternatives, meaning there is scope to add genuine diversifiers with return patterns different to traditional assets.
Markowitz’s work showed that as more assets are added to the portfolio, unrewarded (asset-specific) risks can be diversified away. These assets, however, are still subject to an inherent return premium that can be explained by some underlying common factors. This challenges traditional asset class thinking that distinct asset categories differ significantly. Instead, they might have more similarities in return drivers than previously thought.
Having an in-house risk team means we can look under the hood of certain asset classes and identify common factors that may be impacting the performance of the portfolio.
Just as a painter looks upon different colours to convey different emotions and textures, we can evaluate specific traits or ‘factors’ that historically influence returns. Each factor is like a unique colour on a palette, contributing to the overall risk/return profile of the portfolio.
Imagine a factor palette with these colours:
The list of factors in which we can have an opinion on is extensive. These include macroeconomic factors which correspond to the principal drivers of asset class returns such as GDP growth, real interest rates and inflation. Factors can also differ between asset classes and fixed income factor exposures could include, duration, convexity, and credit spread to name a few.
Factor diversification is a relatively new concept that is gaining attention. Some portfolio practitioners even view it as a preferred method to traditional asset allocation. We see it as a way to complement the traditional. Factors have the potential to highlight the blind spots that traditional portfolio theory may not cover. By, for example, revealing parallels in characteristics between one subset of fixed income (corporate credit) and a subset of equities, linked by returns to economic growth and company profitability.
Similar to how an artist’s muse guides the creation of a painting, portfolio construction should be guided by the unique needs and aspirations of a client. This trumps attempting to predict the unpredictable shifts in market trends and correlations. It’s about tailoring rather than theories. It is often said in portfolio management that all you can hope for is being right more often than being wrong. Expanding on this, when wrong, the strategy should at least be the right one for the client.
The information in this document is believed to be correct but cannot be guaranteed. Opinions, interpretations and conclusions represent our judgement as of this date and are subject to change. Past performance is not necessarily a guide to future performance. The value of assets such as property and shares, and the income derived from them, may fall as well as rise. When investing your capital is at risk. Copyright Investec Wealth & Investment Limited. Reproduction prohibited without permission.
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