Looking at the returns of even some of the most widely owned funds in the IMA cautious managed sector over the last year shows just how challenging markets have been. The benefits of diversification are commonly understood but many funds still have, I think, too high an exposure to equities while traditional diversifiers such as property have also fallen sharply. In extreme periods, historic correlations often break down and even very uncorrelated assets can become highly correlated – in the aftermath of last summer’s sub-prime crisis, all risky assets were sold off as investor risk appetite collapsed.
Effectively constructing an “efficient portfolio”, where risk is carefully diversified and properly rewarded, is difficult but essential if investors’ needs are to be met. This requires a considered, long-term perspective so that the nature of risks associated with different asset classes and the scope of potential rewards – from both the asset class and active managers’ ability to outperform – can be properly understood.
Multi-asset investing is the current craze and we have seen a huge increase in interest in areas such as commodities, private equity, structured products and fund of hedge funds. Much of this has been driven not by the needs of diversification but by a hunger for higher returns, often with little regard – or even understanding – of the risks involved.
As an example, it should not be a surprise that the returns of commodity stocks are positively correlated to commodity prices – if copper prices go up, copper miners tend to make more money. And yet energy and commodity funds have never been more popular despite one-third of the UK equity market (by market capitalisation) now being made up of energy and resources companies. Is that really a diversifying trade? Or is it a scramble for return?
Other questions to ask of some “alternative investment” funds are whether the liquidity profile is appropriate, whether they represent good value or in some instances – such as fund of hedge funds – whether they are even really asset classes at all? That is not to say that we don’t invest in alternative asset classes – we do – but to my eyes, some of the holdings of a number of cautious managed funds look simply inappropriate.
At Maia, we have limited our equity exposure to 27 per cent – 34 per cent if you include global convertibles – and have chosen to fully diversify globally. Convertibles are a good example of the sort of fund we think is appropriate for a cautious portfolio – offering much of the upside potential of equities but with much reduced downside risk. We have also allocated one-third of the portfolio to a range of absolute return fixed income and equity market neutral funds which are far less sensitive to market movements but which still offer the potential of strong absolute returns, generated through skilful active management. Finally, one-third is allocated to a globally diversified combination of specialised fixed income funds – all sterling hedged to reduce foreign exchange risk.
It is not possible to generate investment returns without taking risk – but the level and nature of the risks must be appropriate for the investors’ needs. Market volatility is high and likely to remain so and effective portfolio construction will be key to ongoing success. We believe that our cautious fund offers real diversification and superior return potential.
Jason Collins is a partner at Maia Capital