Manage risk now to help your portfolio bounce back

An enduring charm of the Homeric epics is the flaws of their chief actors and Odysseus is an archetypal anti-hero. Although brilliant and cunning, the king of Ithaka has angered the gods, condemning him and his men to wander the Mediterranean in search of home.

There are, however, instances when Odysseus nullifies his damaging tendency to hubris. His encounter with the sirens, mermaid-like creatures whose beautiful song enticed sailors to their doom, was seized upon by Dr Davies as an example of the approach investors can take to guard against damaging impulses.

Crucially, Odysseus doesn’t avoid listening to the sirens, much as investors won’t want to entirely miss out on the upside from risky assets. Instead, he has his men fill their ears with beeswax and tie him the ship’s mast, thus the vessel passed the sirens’ rocky island in safety and Odysseus could listen to the enchanting music unable to succumb.

Asset allocation makes investors disciplined

Fast forward to the worst economic conditions since the Great Depression and adherence to the principle of knowing you’re going to make some bad calls has, so far, reduced damage to our portfolios from stock market turmoil.

Since the end of November, when the Sars-CoV-2 coronavirus was still unheard of in the West, our tactical asset allocation portfolio (TAA) has lost 5.6 per cent; at the worst stage the peak-to-trough drawdown in its value was over 26 per cent. Clearly, that’s a bad performance but compared to just owning a FTSE 100 tracker, the drop was moderate.

Going back further and another diverse portfolio, our ten-asset system, saw its peak-to-trough keep to a fall of less than 20 per cent. We last rebalanced in February 2019 and, from this date, we’re only down 1.3 per cent overall.

At one point the ten-asset system was up 8 per cent, below the 10 per cent total returns from the FTSE 100 tracker at its peak, but prospect theory tells us investors hate losses more than they like gains. Down less than the FTSE 100 tracker now, our portfolio has demonstrated a more palatable trade-off between risk and return.

Knowing you can be your own worst enemy

Our portfolios have not suffered less because of clever security selection. The TAA especially was aggressively positioned and has been completely wrong-footed by the Covid-19 pandemic. Despite its shortcomings, the asset allocation is a safety rope, which is why Dr Greg Davies’ metaphor is apt.

Although the November TAA selections stuck to the narrative that equities are the only way to achieve meaningful long-run returns, there was restraint. Holding cash and short-dated government bonds dilutes falls and, despite rising positive correlations, riskier assets don’t move completely in step with one another.

With shares, equity indices focussed on regions have different currency and industry exposures, which lessens the pain felt from a heavily weighted sector in one index. For example, the FTSE 100 has suffered thanks to the size of oil majors Shell (RDSB) and BP (BP.) and the prominence of banks, who were among the first big companies to axe dividends.

Strategic versus tactical asset allocation

The ten-asset system, an equally weighted selection of exchange traded funds (ETFs) and cash, is a truly passive approach at the portfolio and the security selection level. No calls are made on whether a particular asset class, region or theme will outperform – the idea is that by spreading risk and staying invested, returns will come good over time.

The strategic risk-weighting decision was to always rebalance and have 40 per cent of capital invested in shares; 20 per cent in government bonds; 10 per cent in global real estate; 10 per cent tracking commodities futures; 10 per cent in gold; and 10 per cent in cash.

Within the allocation to shares, there is an equal split between the FTSE 100, the FTSE 250, global value stocks (with quality safeguards) and emerging markets. Half of the bond holdings are short-dated UK gilts and the other half are index-linked gilts, known as linkers.

The TAA portfolio is more fluid. At present the high-level asset allocation is 65 per cent equities, 17.5 per cent bonds, 7.5 per cent real estate, 5 per cent gold and 5 per cent cash. The decision before Christmas, to take more equity risk, was punished but having over a third of the portfolio in other assets has meant a wrong call for the short-term is easier to absorb.

Trading off risk and reward, the TAA has also been better than UK large cap shares alone. Before markets became rattled by coronavirus, the portfolio’s high point was being up 3.5 per cent, matching the FTSE 100 tracker’s peak since the end of November rebalance. That’s despite the TAA being significantly less volatile and its peak-to-trough drawdowns have been shallower.

Looking forward

Unlike the FTSE 100, which is an index dominated by large companies in structurally challenged industries, the TAA had an ambitious tilt towards businesses of the future. Some of the funds hold growth companies whose profits are vulnerable in a deteriorating economy and re-appraisals of the value of these businesses has dragged down performance.

Investment trusts focused on fintech, artificial intelligence and sustainable green businesses haven’t done well and even our infrastructure fund has had a rocky first quarter after an impressive 2019. Getting timing wrong is a risk of TAA, but this is semi-active investment, with convictions for the long-term. The point is, that by making these decisions within a framework, the damage of being wrong is limited.

Over time, if the logic behind selections is proven incorrect, it is psychologically easier to move on as losses will hopefully be offset in the portfolio. Although, looking back at the TAA, the regret isn’t what we added in November, it’s that there isn’t a specific healthcare fund to capture another 21st century mega-trend.

Having 10 per cent of the equity allocation in listed infrastructure has disappointed so far in 2020 but owning a slice of businesses that, in ordinary times, have high demand for their services and barriers to new competition is a good policy.

Increasing exposure to the UK economy with a tilt towards the FTSE 250 at the end of 2019 was a bold TAA call that seriously backfired with coronavirus. The FTSE 100 allocation was scaled back at the same time, which, given the preponderance of oil and banks, has been a good thing.  

Overseas shares are more of a theme in the TAA and, although the holdings in US, Japanese, emerging market and eurozone equities have decreased in value, being internationally focussed will cast the net wider for upside in what is likely to be a bumpy and uneven global recovery.

With benefit of hindsight, ditching US treasuries (American government bonds) was a mistake, this position would have further off-set losses from shares in the flight to safety. It would add to US dollar exposure in the portfolio, useful if sterling comes under renewed pressure, which can’t be dismissed given the expansion of the UK government’s deficit and the scale of the economic contraction unfurling. Of course, the US has shown monumental fiscal largesse but as the global reserve currency, the dollar remains a haven.

Index-linked UK government bonds was another asset that did well in the sell-off and the ten-asset system was buoyed by its linkers. The return has been due to price increases in the value of these bonds, which means retail investors must tread carefully.

Typically, funds hold linkers with longer to maturity, so the bonds are sensitive to interest rates. Counterintuitively, if inflation comes back from the low level in the first phase of this economic crisis, exposure to linkers will add downside risk to portfolios. Although the yields on linkers will rise, the prices of the bonds in issue (which move inversely with yields) will fall by a more significant amount.

Linkers are a great asset for institutional funds that invest over a very long horizon and engage in liability matching over time but for private investors, they are a hedge on the recovery playing out slowly and in phases. That might not be a bad call, and arguably linkers should be a small part of strategic asset allocations, but we don’t own them in the TAA already and the risk of buying in at current prices is probably skewed to the downside.

Corporate bonds have held up, thanks largely to the gargantuan support given to money and credit markets by central banks to help companies maintain their funding lines. Overdraft credit facilities were the first port of call for companies and the availability of cash decreased the likelihood of default, for the bonds with one to five years until maturity, in the index our fund tracks.

Our TAA had no investment in longer-term finance, so the impact of the early-crisis spike in credit spreads (the difference in the yield lenders demand companies pay compared to safe government debt) was not horrendous and our holding is not down by much.

With the Federal Reserve standing behind credit markets, our holding in riskier corporate debt has recovered from March lows. Thanks to the weakness of the pound, our largely US dollar returns have translated positively, even though the index is still off its highs at the start of the year.

Gold is once again proving its worth as a portfolio diversifier. It didn’t escape the sell-off at the end of February, as fund managers sold out to cover other losing positions, but the TAA holding is now up 17 per cent since the rebalance.

As a store of value and haven asset, gold offers protection in the deflationary period we are enduring. Furthermore, gold is an anchor of value when inflation returns, which down the line could be a nasty consequence of fiat currencies being debased by central banks’ money-printing.

Building back with restraint

Being honest, there are some serious drawbacks to the 10-asset system. Its fixed income (bonds) exposure is entirely sterling denominated and the equities allocation is also too UK-centric. The overseas shares allocation is a heavy value tilt, so there isn’t enough of a strategic weighting towards Nasdaq-listed big tech.

Ten-asset system (equal weighted again from 20.05.2020)

Table source: Factset and Investors Chronicle

Diluting the presence in portfolios of the so-called FAANGs - Facebook (US:FB), Apple (US:AAPL), Amazon (US:AMZN), Netflix (US:NFLX) and Google’s parent Alphabet (US:GOOGL) - had been mooted for a couple of years thanks to their eye-watering valuation. The argument was far from baseless but being out of these stocks hasn’t played out well in this crisis. Besides, unless it’s for moral reasons, being underweight some of the world’s biggest companies is a tactical move, not strategic asset allocation.

Finally, tracking commodities futures with 10 per cent of capital is too much, especially when the FTSE 100 already links you to the fortunes of big oil and mining companies. Yet, for all its failings, the 10-asset system remains an ongoing experiment in passive strategic asset allocation and shouldn’t be tampered with.

Meddling with the TAA is a harder temptation to resist. In hindsight we should have had some UK-linkers, some US Treasuries and prioritised biotech in the thematic equity tilts, partly in place of FTSE 250 shares.

In making changes, we will undoubtedly fall prey to cognitive dissonance. For instance, we could be chasing gains after the upside has been had because expectations have been anchored to the recent experience.

Loss aversion could also be at play, manifesting itself in one of two ways. Firstly, there is the mental discounting effect that leads investors to ‘quit while ahead’ and sell winning positions too soon. In the opposite situation, when assets fall in value, a reluctance to crystallise losses and be left feeling stupid, compels people to run losers hoping for them to come good.

Rebalancing the portfolio now will incur charges so only one change is made, that is to ditch the FTSE 250 holding and buy into The Biotech Growth Trust (BIOG), so that it is now five per cent of the current portfolio value. The remainder of proceeds from the sale will be held as cash.

While shares in this trust are still trading at a discount to their net asset value (NAV), the z-score of the discount’s historic range is positive, indicating that the trust shares are less of a bargain than they were in the past. Furthermore, NAV and the share price has risen a great deal already this year, so there is a risk we are coming late to the growth story.

This could be an example of recency bias, but advancing biotechnology is a long-term trend and having international holdings in an area primed for structural growth is more appealing than the L-shaped performance (from its fall through to a slow recovery) of the FTSE 250 index, especially as so many UK companies are cutting dividends.

Being focussed on the whole portfolio, not individual securities, is like the rope and beeswax for investors. Just as Odysseus knew he was going to be compelled to dive towards the sirens and had himself bound, we know loss aversion is going to creep into decision making, so we broadly stick to an asset allocation.

Thematic growth investments now make up 20 per cent of the TAA portfolio, almost a third of the equity allocation. Holding onto these conviction plays, especially when they have fallen considerably (like the fintech fund), may be right or it may be reluctance to admit being wrong. Yet, with considerable index exposure to the universe of larger companies in the US, UK, Japan and eurozone, a dud individual call will matter less.

The extra slug of cash will also help cushion any disappointments, which is important as there will be some as we navigate choppy waters, although, to get the best of a recovery you sometimes must sail towards risk, as Odysseus chose to. Understanding this, and being circumspect like him, will help portfolios catch a fair wind when the storm has passed.

Tactical Asset Allocation Portfolio 

Table source: Factset and Investors Chronicle

*Cash allocation added to in May 2020 with part of sales from FTSE 250 holding