There’s More To Diversification Than Not Having All Your Eggs In One Basket
Don’t put all your eggs in one basket, the old investment adage goes.
And while the importance of diversification cannot be stressed enough, mere diversification is not enough. “The old cliché is don’t have all your eggs in one basket, but you also need to understand that you can’t only have eggs,” Philip Bradford, head of investments at Sasfin Wealth, says.
What Bradford is referring to is the importance of understanding the interplay between various asset classes in a multi-asset portfolio. Although investors ideally want to ensure that all the building blocks in their portfolio do well in the long run, they don’t want to be in a position where all assets are struggling at the same time. A classic example is bonds and equities. Over time, investors tend to find that when equities are not doing well, bonds outperform, Bradford says.
Conventional wisdom dictates that equities will outperform other asset classes in the long run. As a result, the assumption is often that equities are the only asset class investors should utilize. But history doesn’t necessarily support this assumption, Bradford says. While South Africa has been the best performing stock market in the world over the last 100 years, there are other asset classes that have also done very well in Rand terms.
Bradford says a lot of investors argue that they would have been in a more favourable position had they gone offshore 30 years ago, yet in many instances investors would have been better off investing in Rand assets. Even though the Rand depreciated from about R2 to R12 against the dollar over the period, high-yielding local assets like cash and bonds have still done better than some of the equivalent foreign asset classes. As an example, over the last 20 years SA bonds have comfortably outperformed global stocks by nearly 1% per year on average, including the depreciation of the Rand.
Currently, local cash and bonds provide investors with a significant pickup over global cash and bonds and it makes sense to get a strong “base load” return from these assets that are already comfortably beating inflation, Bradford argues. “In the local market, if you can currently get inflation plus 4% or 5% out of bonds – which are actually going to protect you when the equity market falls – what it does allow you to do is to dynamically move between those asset classes when equities under-perform. Bonds are essentially like an insurance policy that instead pays you a premium.”
If equities pull back, other assets may still be doing well and the portfolio can be re-balanced. “Simple strategies like regular re-balancing actually add a lot of value in the long run.” It also allows investors to invest “more opportunistically” into equities.
“I wouldn’t say that the right asset allocation is to be in equities and then when things look bad go into cash or bonds. If anything, there is a very strong argument over the longer term that your fixed income assets (particularly the local ones) can give you compounding growth because they are currently – literally by the nature of the instrument – offering decent real returns with a high degree of certainty.”
Although the tide seems to have turned for the South African economy, this does not necessarily mean the local stock market will do well. These developments are discounted quite quickly. Moreover, many locally-listed companies earn the majority of their earnings offshore, Bradford says. An improved economic outlook may well support local retailers as well as banks and insurers that are sensitive to interest rate movements, but there are probably only a handful of local stocks that could be considered world class, he adds.
“When you are looking at equities I think you do need to look at things with very much a global mind-set and be aware that the vagaries and movements of currency markets will impact those returns, but over time I do believe there are opportunities out there that you can’t get on your doorstep in South Africa.”
Bradford says for local investors looking to increase offshore exposure it makes sense to focus on equities, simply because investors are taking a lot of currency risk. “The argument for going offshore and investing in cash or bonds for me is a very weak one, particularly at these sorts of levels and the kind of yields that are available.”
“I don’t think most people appreciate the currency risk they are taking. They feel safer by taking the money offshore but because they are getting a much lower yield on their [cash and bond] investments offshore it isn’t typically compensating them for the additional risk that they are taking.” “If you took R100 and bought US Dollars 30 years ago, it would now be worth R1 769 (including interest and Rand depreciation). However if you kept it in cash in Rands, it would now be worth R2 448. Basically the higher interest rates in SA more than compensated you for any currency risk.”
In contrast, global equities offer a similar valuation to local equities and far greater range of higher quality companies to choose from, he argues. However, other local asset classes like fixed income and local property offer very high yields compared to the global market. Local property offers a very high rental yield because the escalations in leases are linked to inflation and are much higher than in developed markets. “So whether you are a retail investor or an institutional investor, the local assets that are available to you can give you high yields that you can’t get in the developed market.”
Bradford says a lot of private investors tend to include only equity and cash-type investments in their portfolios, ignoring assets like bonds. “But actually, it is those in-between investments than can often add your best bang for buck from a risk-adjusted perspective and can seriously improve your returns over time.” While local pension fund portfolios tend to have a higher equity exposure than their global counterparts – a strategy that has worked well over time – it will likely become increasingly difficult to achieve the inflation-plus type targets investors have become accustomed to in the past.
“I think we need to be a lot more cognisant of not necessarily trying to beat the market – or active versus passive – but try and get the best risk-adjusted return we can for our investors.”
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