Last month’s column (Keep calm and carry on’, 9 April 2020) touched on the unprecedented rise in correlation between a number of asset classes, including bonds and commercial property, which has surpassed that of even 2008. There have been few safe havens during the recent market downturn – a downturn that has also been characterised by significant discount volatility. While important to retain perspective, this has implications for portfolio construction when seeking diversification. And given the recent market bounce, now is a good time to consider these given the likely return of volatility.
Diversification is an important investment discipline, yet one that is often overlooked. When starting an investment journey, it makes sense to focus on equities for their superior return over the long term – they have performed better than most other assets. However, as time passes, investors should increasingly be looking to protect past gains, particularly if financial goals are approaching for market corrections can be cruel in their timing and devastating in their effect.
Diversification seeks to reduce portfolio risk by increasing exposure to 'uncorrelated' assets – other asset classes that tend not to move in the same direction as equities over the same period. While few investments will entirely escape a major equity market correction, adequate diversification will help to reduce losses.
Other assets can also help achieve a high and growing income, which becomes an increasingly important contributor to total return over time. This is particularly relevant to income investors at a time when the balance sheets of many companies are looking increasingly stretched. For such investors, the investment journey should involve a shift towards good-quality higher-yielding holdings within the declining equity exposure.
The recent market correction has seen discount volatility. Once past its peak on 19 February 2020, the sector (FTSE All-Share Equity Investment Instrument index) fell 34.9 per cent in a month. The index breakdown by asset class is broadly equities (66 per cent), alternatives (23 per cent), flexible (6 per cent) and private equity (5 per cent). The weighted average discount of the Morningstar All Investment Trusts excluding alternatives (essentially all equity and flexible investment trusts) widened from 3.8 per cent to 16.7 per cent, before narrowing back to 3.9 per cent within two months.
Volatility should be expected from investment trusts at times like these. It is the price investors pay to access their superior returns over time and why they are best suited to long-term investors. However, the period has been among the most volatile in living memory. There has perhaps been an element of inertia in that discounts initially failed to reflect wider market concerns, while poor marketability has also probably contributed at times at the margin.
While accepting these are difficult times, there has also been an unprecedented rise in correlation between different asset classes. Certain assets have done better than others, but there have been too few ‘safe havens’ during this storm, which has seen hitherto traditional stalwarts disappoint. Both this and the heightened volatility suggest a reappraisal is required when seeking diversification.
There’s nothing to suggest from the latest crisis that the pace and extent of diversification needs a re-evaluation. An investor's income requirement, risk profile and portfolio size relative to other assets will remain key factors. There are no fixed rules. By way of illustration, five of the nine real investment trust portfolios run in real time on the website www.johnbaronportfolios.co.uk pursue an investment journey that sees them increasingly embrace other asset classes. The open Diversification page highlights the pace and extent.
The two portfolios covered in this column are part of this five portfolio risk-adjusted investment journey. The approach so far has been to invest essentially in five asset classes – corporate bonds, infrastructure, renewable energy, commercial property and cash. Each has had a role to play in helping the portfolios on their journey over the past 11 years and, to varying degrees, will continue to do so. But changes are required in balance, and further assets introduced.
Examining the tea leaves
We should perhaps remember that diversification will not entirely protect a portfolio in a major market correction – it can only cushion the fall. Meanwhile, the very construct of the concept will see the various assets perform differently even though globalisation has contributed to a rise in correlation between certain asset classes. So investors should retain an element of perspective when re-examining the components and the market’s view of the various asset classes, for the next crisis is unlikely to be a repeat of the last.
Commercial property has not been a safe haven despite robust government support for businesses and the sector generally being in better shape than it was during the last financial crisis. The market’s concern relates to rental income being cut as businesses struggle to adapt to the economic downturn. Given the real estate investment trust (Reit) structure of some well-run companies such as AEW UK REIT (AEWU), there are few revenue reserves to fall back on.
Furthermore, companies will be wise to accommodate tenants’ concerns as best as possible given the human dimension of this crisis and the goodwill needed once the recovery takes hold. In accepting the short-term hit to income, the market is trying to ‘peer through’ to the recovery when the material discount to net asset value (NAV) may be supportive. At the moment, uncertainty prevails. Furthermore, in the long term, there may be more profound implications for the sector as more flexible working practices take hold.
Corporate bonds have also tended not to provide safe passage during this crisis. The higher-yielding ones have been particularly volatile – CQS New City High Yield (NCYF) is showing a 55 per cent drop in price since the year-end and remains 22 per cent down at the time of writing. Yet while accepting gilts have held up well, they continue to look poor value over the medium to long term – particularly if inflation picks up.
Unlike companies in the property sector, the portfolios’ corporate bond holdings possess revenue reserves to varying degrees. Invesco Enhanced Income (IPE), Henderson Diversified Income (HDIV) and NCYF have stored income from previous years for situations of this sort when some of their holdings may default on interest or dividend payments. NCYF has over one year’s worth of reserves which, being very conscious of its dividend record, it is prepared to use as necessary. The sector remains undervalued.
Otherwise, the portfolios’ infrastructure and renewable energy holdings have so far fared better. HICL Infrastructure Company (HICL), Bluefield Solar Income Fund (BSIF) and JLEN Environmental Assets Group (JLEN) have by and large seen more modest price falls despite concerns about long-term power prices. These holdings should continue to deliver attractive and growing income levels that are sustained by stable and predictable cash flows – some being inflation-linked. While pursuing important remits in their own right, such qualities will become increasingly valued as dividends are cut elsewhere.
Cash, the best diversifier of all, has also once again proved its worth during the correction. Increased exposure as the five-portfolio investment journey progresses has certainly assisted. Whether an investor accepts or not Warren Buffett’s view that cash is a call option with no expiration date or strike price, it helps reduce forced selling and enables portfolios to take advantage of opportunities. It will remain an essential component.
But the latest crisis also highlights that something more is needed. We need to question the ability of those with influence when assessing and managing risk. Covid-19 is not a ‘black swan’. A major government assessment only a few years ago, and many esteemed epidemiologists over recent years, identified a pandemic as a most likely danger. And yet the large financial institutions have not factored this at all into their various and costly assessments of market risk – once again, reminding us of the folly of forecasting.
This is unlikely to change going forward. While this crisis is not yet over, the next crisis will probably be different. It may also happen more quickly than previously thought or theory suggests. Recent events have shown that, in sum, greater resilience is required from chosen investments when seeking diversification. The good news is that they exist. And while they may not be mainstream, the investment trust sector proffers exposure to most of them.
Examples of more robust investments include derivatives that hedge against market falls, whether they be, for example, VIX calls that benefit from volatility or equity put options that benefit from market falls. Index-linked bonds also have a good pedigree in this regard, and may be a good investment in their own right.
Together with a modest weighting in good-quality equities, gilts and cash or near-cash equivalents, these types of investment are the bread and butter of a collection of investment trusts known for their focus on capital preservation – Personal Assets Trust (PNL), Capital Gearing Trust (CGT) and Ruffer Investment Company (RICA). The quid pro quo for this focus is a lack of yield.
But most also have modest exposure to gold in one form or another. In a world of high debt and low interest rates, with inflation on the horizon and uncertainty perhaps a more frequent visitor, gold is looking a more attractive medium-term investment in its own right. It also usually performs well in times of crisis. The problem for those investors seeking more exposure is that the asset is not well represented in the investment trust sector.
There are mining trusts that have a decent weighting – BlackRock World Mining Trust (BRWM) presently has exposure of approximately 25 per cent. But there are no trusts focused on the physical asset, for perhaps understandable reasons. However, suitable alternatives exist in the world of exchange traded funds (ETF). Unusual times can require unusual measures.