A globally diversified equity portfolio seemed to make sense in a bull market. If we take the perio...
A globally diversified equity portfolio seemed to make sense in a bull market. If we take the period 1982-2000, the last great secular bull market before the bear crunch of the last three years, an optimum portfolio necessarily included some exposure to the major equity regions. The mantra of diversification dictated the balance between risk and reward; the best place to be was within an international portfolio.
In a steadily rising equity market, it made a great deal more sense to diversify by geography. For a sterling investor in particular, once they had got over the issue of currency, it seemed logical to participate in the 90% or so of equity that existed outside the UK home market. For those investors new to equities, prudent advice often pointed to the advantage of starting with an international portfolio rather than solely UK equities.
Has the pain of the last three years, namely continuous losses in equities on a rolling-year basis from March 2000 to March 2003, done anything to undermine the belief in global diversification? On the surface, no, it has not. What the last three years have done, however, is dented the overall belief in equities as a sound investment over the medium term, namely three to five years. It may also have revealed the advantage of other asset classes for the short and indeed medium term, such as fixed income and cash. The alluring premise behind global diversification remains the same, except that it seems to work in reverse. Instead of maximising gains for the minimum amount of risk, investors are beginning to appreciate the benefits of global exposure in minimising losses at a time when markets are inherently risky.
The fact that investors have been reminded of market risk raises the important fact the secular bull market led to an over-reliance on benchmarking. Until 2002, and possibly up until the present in certain areas of the investment world, risk was measured predominantly in relative terms. In other words, tracking errors, betas and other risk measures against a benchmark, or index, became the norm. The danger with this approach is that, when taken too far, it can hide the absolute risk inherent in equities as an asset class. To know a fund could lose 18% of its value in a year rather than 22% may be impressive in relative terms, but is less of a comfort in absolute terms. Measures such as standard deviation are probably more useful as an absolute tool.
How could one protect a portfolio during a bear market? Time horizons are crucial when dealing with this issue. If one is firmly committed to equities, one should remember there have been quite extensive periods in the past where returns have been either negative or minimal. Examples include modern-day Japan, the US in the period January 1929 to January 1939 and also in the period January 1973 to January 1983. If an investor wishes to see positive returns during these, historically speaking, unusual phases in equity market cycles, it may help to diversify away from equities and seek exposure to other asset classes such as fixed income and cash. Many diversification opportunities exist outside equities as well. In fixed income, for example, there lies the opportunity of choosing between government and corporate bonds. Within both these areas of fixed income, there also lie further diversification opportunities by geography or sector.
History tells us that only 20-year time spans or more can act as a quasi-guarantee to positive returns in most equity markets. As in all ventures, however, it may be prudent to avoid extremes when looking at a portfolio. Some market commentators raise the arguably valid point that being under-exposed to equities as we begin the second quarter of 2003 may be as short-sighted as being over-exposed to equities at the end of 1999. However, history also tells us the principle of 'mean reversion' is often a useful guide. In other words, extreme moves in one direction are often followed by an extreme move in the opposite direction. The fact that global equities have seen negative returns for three years is no indication of future performance.
Correlation between equity markets has also risen during the bear market of the last three years, as indeed it did in line with greater globalisation of trade in the last few years of the bull market. Whereas it may have done wonders for a global portfolio's relative returns versus global equities to be overweight Japan from January 1982 to January 1990, then underweight Japan from January 1990 to January 2001, this top-down exercise has become less clear-cut.
Although regional equity markets do move more in line with each other, it is nevertheless also interesting that returns between the best 25% of individual companies and the worst 25% have widened. Global exposure to equities remains a relatively attractive prospect compared with a regionally-constrained exposure, although the emphasis on stock picking seems to be growing in importance.
Putting the tech into protection
Square Mile’s series of informal interviews
Fallout from Haywood suspension
Launching later in 2019
£80bn funds under calculation