Big change for South African investors

The behaviour of asset classes is beginning to change, impacting the performance of investor portfolios, increasing the risk associated with investing, and decreasing the benefits of traditional diversification. 

In particular, bonds are beginning to move in sync with equities around the world, making them increasingly correlated and, thus, less useful for diversification. 

This is feedback from Old Mutual Investment Group (OMIG) portfolio manager Graham Tucker, who outlined the changing landscape for asset managers.

Presenting OMIG’s annual Long-Term Perspectives report, Tucker outlined some of the basic principles of investing. 

The report aims to analyse investment trends and outline lessons for investors over the long term, using OMIG’s extensive data going back 95 years. 

Tucker explained that investors struggle to handle the volatility of equity markets, often making emotional decisions to sell or buy a stock based on short-term price movements. 

This leads them towards more conservative assets, such as cash and bonds, to protect against volatility and prevent the permanent loss of capital. 

However, this comes with the risk that their investments may not outperform inflation over the long run, resulting in a decline in their purchasing power. 

As a result, many investors find themselves in a dilemma, as they cannot stomach the volatility of equities but want to achieve positive long-term investment outcomes. 

This is what makes balanced funds so attractive to investors, as they can smooth out the volatility of equities through diversification, Tucker said. 

Balanced funds are multi-asset portfolios, with asset managers determining exposure to various asset classes to limit volatility without sacrificing long-term performance. 

Tucker explained that over the past decade, these funds have gained popularity as uncertainty and volatility have increased. 

OMIG’s Balanced Index, which tracks the performance of a model-balanced portfolio, shows that such a fund can significantly outperform inflation and more conservative asset classes over the long term, without much volatility. 

This is evident in the graphs below, which compare the Balanced Index’s long-term performance to other asset classes and its relatively low volatility. 

Times are changing

The balanced strategy has proven effective for both asset managers and investors in the past, generating strong returns with reduced volatility. 

However, this may no longer be the case with regard to traditional balanced funds that are predominantly invested in equities and bonds. 

These portfolios are based on the idea that bonds and equities behave differently, as they are uncorrelated assets. This provides some protection against external shocks and downside risks. 

Tucker explained that this was a perfectly good diversification strategy over the past twenty to thirty years, with equities and bonds being uncorrelated. 

More recently, however, they have begun to move in sync and are becoming increasingly correlated. This undermines the diversification benefit from investing across these asset classes. 

As a result, traditional balanced funds are increasingly impacted by elevated volatility and uncertainty, with the traditional role of bonds as smoothing out the short-term fluctuations being diminished. 

Tucker explained that this has increased the need for alternatives to traditional balanced fund allocations, split between equities, bonds, and cash. 

One way investors can achieve this is by increasing their exposure to other equity and bond markets outside of South Africa, thereby enhancing the resilience of their portfolio against local factors. 

This is also likely to result in enhanced returns as global equities, particularly US-listed companies, have outperformed other asset classes by a wide margin. 

Tucker also noted that asset managers are increasingly allocating capital to alternative asset classes, such as gold, which is highly uncorrelated with equities and bonds. 

Other alternatives include investing in traditionally ‘safe’ currencies such as the Japanese yen and the Swiss franc. 

Many of these alternatives aim to replicate the historic role of bonds in mitigating the short-term volatility of equities.