In uncertain times, investors are constantly on the lookout for ways to reduce risk in their portfolios, while still achieving their long-term investment goals.
This is a particularly pertinent issue for investors facing key landmarks in their retirement planning. A sharp fall in the underlying market just before retirement can have a major impact on the value of a person’s portfolio, as one shifts assets into a post-retirement vehicle.
The textbooks tell us the best way to mitigate this risk is through a diversified portfolio. A spread of asset classes (for example a portfolio containing equities, cash, property and gold), geographies (to offset the currency risk of holding assets in rands) and equity market sectors (for example a mix of financials, mining companies and tech) can go a long way to helping investors to achieve these goals.
The philosophy of diversification is simple: a core portfolio complemented by investments whose return profiles are uncorrelated with the core.
To use a simple example, an investor might hold a broad portfolio of shares but with some exposure to gold or bonds. Because equity market returns have historically not been correlated with gold and bonds, these provide some protection during times of stock market weakness by either rising or holding their value.
Another example is to hold shares that are considered rand hedges – these shares will typically appreciate in value (in rands) when the rand weakens.
A well-structured portfolio using these sorts of strategies can go a long way to reducing the risks of a volatile market. However, these strategies are not without their shortcomings.
Beyond traditional diversification
One problem is “diworsification” – investing in too many shares and asset classes that it ends up diluting performance over the long term.
Another is that the investments made to hedge the core portfolio don’t always perform as expected. For example, during the financial crisis of 2008, global bonds did not provide protection against a falling equity market, with the two asset classes both coming under severe pressure at the same time.
Similarly, equity market sectors with very different fundamentals may also fall simultaneously during times of stress.
Given these potential shortcomings, modern investors are always on the lookout for new and effective ways to hedge the risks affecting their portfolios, either through new opportunities or through instruments that provide clear, definable outcomes.
New investment strategies on the market
Thanks to market innovation, these strategies are becoming increasingly available to investors.
Investors can now invest in structures designed to deliver certain targeted outcomes, according to market conditions, using underlying derivatives or other market instruments to achieve this. Structured products and notes are good examples and will typically reference an underlying index to provide geared upside while offering a degree of capital protection (often 100%).
Other investments provide access to asset classes and sectors not easily available on global exchanges, into so-called alternative investments. Good examples are private equity, credit, and hedge funds. While not typically liquid asset classes, they may suit certain investors looking for different ways to diversify. Others may provide access to parts of the debt market not generally available to investors.