LEIGH KOHLER: Wild financial markets call for deeper diversification

Turbulence in investment markets is here to stay. The era of cheap money is over, and with it the promise that stocks will always march higher and bond yields lower. When wild swings in market prices become the new standard, diversification across a broad spectrum of assets forms the backbone of any sound investment strategy.

For financial advisers working with their retail clients or collaborating with an asset manager, building a bulletproof portfolio is nearly impossible when the ground is constantly shifting and the investment and regulatory landscape is becoming increasingly complex.

US treasury secretary Janet Yellen admitted earlier this year that she was wrong when she said in 2021 that inflation would be manageable and pose only a small risk. The world’s most influential central banks were also behind the curve on rampant inflation. As a result, interest rates may need to increase faster and monetary stimulus unwound far more aggressively than initially anticipated — potentially inciting a recession.

In June the US Federal Reserve raised interest rates by 75 basis points, the biggest increase since 1994, after two prior increases of 50 basis points each. It pledged to continue the second component of its strategy to cool red-hot inflation by shrinking its $8.9-trillion balance sheet and allowing the bonds it holds to mature.

The European Central Bank plans to raise its base rate for the 19-member currency bloc by 25 basis points in July, with a potentially larger increase in September. Its bond purchases programme will also stop in July.

As these and other tightening measures by other central banks worldwide drain cash out of the financial system that could otherwise be used for investments, emerging markets, global equity and fixed-income markets have suffered.

The outlook seems almost catastrophic. But things may change. The much-feared contraction in the US or Europe could play out, forcing policymakers to temper rate hikes and quantitative tightening measures. That too could have other unpredictable consequences.

Discretionary manager

When it comes to investing, not having all your eggs in one basket removes some uncertainty. Financial advisers could follow the traditional approach of spreading their clients’ funds across different market sectors and asset classes or geographic diversification through exposure to SA and global counters.

There are other ways of enhancing that diversification even further. When a discretionary fund manager has the freedom to choose which assets to buy and sell on behalf of a financial adviser’s clients. 

The discretionary fund management (DFM) industry has boomed. DFM assets under management are estimated at R400bn, according to the Collaborative Exchange. According to a survey by NMG Group, 83% of independent financial advisers sampled in 2021 are looking at forming an investment relationship with a DFM compared with 70% in 2020, showing more growth is still to come.

A DFM provides financial advisers with other services such as research, tailored portfolio construction expertise and the latest technology to streamline their business, such as back-office administration and governance processes. It acts like a multimanager and farms out the funds it gathers from the financial adviser’s clients to other money managers, which it researches daily to seek out the ones providing the best, most consistent risk-adjusted returns.

Typically, most DFMs stick to large, well-known stable asset managers to unlock steady returns that reflect developments in the broader market with a small out- or underperformance relative to comparable funds or specific indices or other benchmarks, like inflation plus two percentage points.

React quickly

The world is just too complex for this simple approach to portfolio construction. Financial advisers and investors can use another, fresher and more dynamic approach: niche and nimbler money managers can be combined with local and global giants within a portfolio to add a little spice to the client’s investment pool.

By including handpicked smaller asset managers within a portfolio, advisers and their DFMs allow them to express their best investment ideas across multiple asset classes, react quickly to any price dislocations, follow different investment styles and strategies, and use their various skill sets to employ distinct mandates.

Markets have become hard to predict. The S&P 500 index briefly flirted with a bear market and is having its worst start in more than 70 years. Growth stocks are in bear territory, with the technology-heavy Nasdaq down more than 20%. Bond yields have soared on fears of higher inflation.

The days of simply buying an index and riding the wave are long gone. Active portfolio management is needed when the megastocks or US Treasuries, traditionally touted as safe bets, have been hammered in the chaos.

Investors view everything through the lens of inflation and how central banks will react against the backdrop of uncertainty caused by Russia’s war on Ukraine, the subsequent energy shortages and the ever-present risk of further supply chain snarl-ups should China again shut down its economy because of Covid-19.

Adding more agile fund managers to the mix brings flexibility, the ability to construct portfolios that generate returns over time, and a more active approach to investing, all of which are crucial to navigating turbulent markets.

• Kohler is head of discretionary fund management at INN8 Invest, which has R35bn in discretionary assets under management.