When this column last touched on the subject of diversification a year ago, the case for selectivity was made when choosing asset classes given central bank policy had increased the correlation of some assets hitherto considered appropriate – their efficacy was in doubt. The merits of cash were explored. Last month, in being ever vigilant when seeking to protect accrued gains via diversification, the portfolios’ exposure to commodities was significantly reduced – ‘correlation’ was once again the reason.
An important discipline
Given market corrections are part of the investment cycle, the purpose of diversification is to reduce portfolio risk by increasing exposure over time to ‘uncorrelated’ assets – assets that tend not to move in the same direction as equities over the same period. While few investments will emerge unscathed from a market correction, diversification will help to reduce portfolio losses and so protect the past gains accrued from a higher equity exposure earlier in the investment journey – important if financial goals are about to be achieved.
Bonds, commercial property, renewable energy, commodities, infrastructure, ‘real assets’, certain currencies and cash have traditionally been, to varying degrees, examples used by the market. However, these are unusual times. In their frustration to stimulate economic growth, policymakers have resorted to measures once considered radical – prolonged low interest rates, quantitative easing (QE) and negative interest rates.
Such policies have inflated the price of most asset classes, and this has increased the correlation of some previously thought appropriate when seeking diversification – government bonds are one example. We have to be extra vigilant when selecting assets – some may not be as resilient to a market slump as first thought. Investors need to re-examine their logic and assumptions.
Commodities have traditionally been used as rising prices were seen as negative for the economy (and therefore equities) because of the inflationary consequences. However, with concerns about inflation having subsided in recent years, the correlation between equities and commodities has become stronger. Positive or negative economic news is now considered to affect both in a similar manner – commodity price rises suggesting economic growth, which should be positive for both the sector and equities generally, and vice-versa.
Meanwhile, if inflation were the key concern, there are other asset classes that provide a more direct way of benefiting from rising prices, such as infrastructure and renewable energy. These companies’ income levels are largely inflation-linked, and this makes for a good correlation between dividend growth and prices generally. Indeed, their track record is in contrast to that of the commodities sector in recent years.
Given these two portfolios are in fact two of nine real investment trust portfolios managed in real time on the website www.johnbaronportfolios.co.uk, it is perhaps worth mentioning that commodity sector exposure in the other portfolios seeking diversification has also been reduced.
Portfolio changes
During May, the Growth portfolio sold its holding in BlackRock Energy & Resources Inc (BERI) and added to its existing positions in North American Income Trust (NAIT) and CQS New City High Yield (NCYF). Prices achieved were £0.73, £14.55 and £0.59, respectively. NCYF invests predominantly in high-yielding fixed-income securities and represents a more robust means of diversification. The purchase of NAIT is in part because ‘value’ shares look attractive in relative terms.
Meanwhile, the Income portfolio sold its holding in CQS Natural Resources (CYN) and added to its existing position in Invesco Perpetual UK Smaller Companies (IPU). Prices achieved were £0.87 and £5.13, respectively. The majority of the proceeds were left as cash – this being the greatest ‘diversifier’ of all.
KIDs – meeting with the FCA
Further to my column ‘Putting the spotlight on commercial property and KIDs’ (8 March 2019), readers will be aware of the concern caused by the introduction of Key Information Documents (KIDs). I have shared these concerns with the Economic Secretary to the Treasury, John Glen MP, over the past year. Both of us have also raised the issue with the Financial Conduct Authority (FCA) – the regulatory body responsible. Further to this, I recently met with Andrew Bailey, chief executive of the FCA.
The meeting focused on the need to address the fact KIDs can be misleading to investment trust investors when it comes to the assessment of risk, the projection of returns and the comparison with ‘sister’ funds. Each concern was discussed in turn, but the central issue related to the tendency of KIDs to extrapolate recent returns when indicating potential returns in the future – as such, a bull market will result in KIDs suggesting higher returns, and vice-versa.
This might encourage ‘buy high, sell low’ investment behaviour, which is the exact opposite of what should be happening. Unless checked, this could make for a perfect storm in which investors would get hurt. No wonder the Association of Investment Companies (AIC), the sector’s well respected trade body, has been very critical when leading the campaign against KIDs – recommending investors should ‘burn before reading’.
Andrew Bailey highlighted the FCA’s recently announced findings to its 'Call for Input' consultation in July 2018, which agreed the KIDs regulations could cause consumer harm. However, its problem is that its hands are bound by European Union (EU) regulations while the UK remains a member. I suggested the FCA had a moral duty to protect investors given it knew the regulation was flawed, given its own findings regarding consumer harm, and the conclusion of others including the AIC. Action was needed now to stop investors from being misled.
The FCA had consulted its lawyers on the issue but promised to see what more it could do – it accepted the situation needed addressing. The general consensus was that the EU had not been receptive to concerns so far. The FCA would continue to lobby the EU to address these problems – investment trusts not being well understood or used on the continent. I stressed the need for urgency. The FCA agreed that the situation should be tackled as a priority, but noted that the timetable for the UK’s exit from the EU was a factor here. It was emphasised that, given we will be leaving the EU shortly time was of the essence.
I also raised the need for the FCA to be ready to replace or improve these regulations, and amend the guidance regarding the KIDs, once they become the responsibility of the UK. The FCA acknowledged this point. It was emphasised that time was of the essence. The FCA promised to work closely with the AIC and other bodies to explore options and to keep me informed.
