One of the greatest benefits from working in financial services is how it attracts some amazingly brilliant minds – minds who look at things from all different angles, relying on judgement accrued over the years and through studying economic and social rules.
I was recently honoured to attend to a conference which attracted such minds. The theme of this conference was “future-proofing your portfolio”; it seems many would agree that the past 20 years will look nothing like the forthcoming 20.
The rules and metrics that once worked well will perhaps be vulnerable under a more uncertain and volatile future.
For example, take dividend yields, which for over 50 years had yielded a lower income return than government bonds. This makes sense, as unlike fixed income securities, dividends tend to grow along with corporate profits. A low dividend yield today will itself grow as dividend income grows over time along with corporate profits.
Today, however, such a rule would not work, as we are now approaching our fifth year where variable dividend income exceeds government fixed coupon income. This is no temporary blip, and even the most bullish government bond investor sounds less enthused about their asset’s future than perhaps was the case some years back.
Times are different, so future-proofing your portfolios is indeed a reasonable proposition.
Before I continue further, however, perhaps it’s important to reflect momentarily on the past. Over the past decades we’ve seen boom and bust. We’ve seen major bull runs and equivalent market corrections.
The overall long-term trend through such boom and bust has been an upward one, though – one which had seen markets surpass previous heights after each correction. But what if the volatility swings become more excessive? Would it not be reasonable to assume an exaggerated bull market could be followed by an exaggerated bear one?
In my opinion, what appears to be happening is that we have morphed from a period of volatility to a period of uncertainty. Volatility is a statistical figure one can forecast, but uncertainty can’t be measured in the same way. With uncertainty comes both exaggerated bull and bear markets, and any metric becomes spurious.
So here’s the conundrum: if, in fact, we are moving into a period of uncertainty, how can one future-proof their portfolio?
The answer, in my opinion, is to throw away the tools used in the past and look at each asset at its merit in meeting your long-term goals and obligations. While this may sound overly simplistic, what I mean to emphasise here is how the traditional balanced portfolio, holding 30-40% government debt, would only deliver returns below that of inflation, making the total return objective of CPI+ all the more difficult when the “defensive” portion holds assets yielding CPI-.
As Jack Bogle, founder of Vanguard, famously said, “I’ve never met anyone who can market time successfully, nor have I met anyone who’s met anyone who can market time successfully.”
Switching between growth/defensive allocation does not appear to be the solution. as the capital risks of market timing outweighs any potential gain. I mention the obvious here as I fear some have delivered excess peer rankings only through their dialling up the risk exposure towards growth assets. While their peer rankings rate high within this bullish market environment, where markets do correct, no one should be surprised if these peer rankings tumble.
So the best way to “future-proof” a portfolio, at least in my opinion, is to build a diversified portfolio of different assets whose own risk/return characteristics contribute to the overall portfolio’s CPI+ goal.
Ironically, this is actually how portfolios were constructed under previous periods of uncertainty; periods where computing powers were but a fraction of our smartphones. Tracking error, static 60/40 “balanced”, and other current construction metrics have really only been in play since the early 1980s. Assuming you agree, which I accept is a big ask, the challenge of “future proofing” is in keeping the course and protecting against our own insecurities and professional motivations.
To break away from the pack requires a level of individual courage and common sense. Keynes once wrote that the central principal of investment is to go contrary to the general opinion, on the grounds that if everyone agreed about its merits, the investment is inevitably too dear and therefore unattractive.
But what if the agreement isn’t one founded on economic principals, but on business solvency? As an investment professional, what are the business risks of being in a crowd of others losing money over one where we solely hold the wooden spoon? (Rhetorical question.)
This leads me to my conclusion. If indeed markets are likely to remain uncertain, yet the goal remains static at CPI+, this will all fall apart if the expectations from the end investor remain asymmetrical.
If our clients expect to be top-quartile in bull markets but beat cash in bear markets, immunising a portfolio will always be second to immunising our business. To correctly “future-proof” a portfolio will require that our investors share our expectations, and that returns are assessed on how well the total returns match their medium- to long-term objectives.
Anything less would be like riding a swing that only swings up.
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