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Diversification is only half the story

By: Nic Horn, Director and Durban Regional Head, Citadel

Risk Management: Diversification is only half the story

Rising global headwinds, heightened market volatility and the growing threat of a global recession mean that, as we approach the end of the current economic cycle, ensuring that your investment portfolio has the appropriate safety measures in place is more important than ever. But while we’ve all heard the adage that the key to managing risk is diversification, the truth is that this is only half the story.

First, it’s important to distinguish between risk and volatility. Risk is the danger of losing money or damaging your capital base. Volatility is simply volatility.

The trouble with volatility, however, is that it is asymmetric. The impact of negative volatility on portfolios outweighs the benefit of positive volatility, placing investors on the back foot. For example, if you had R100 invested, and your investment lost 20%, you would be left with R80. To regain your R100, you would then need to earn back 25% on the remaining R80. In other words, your investment would need to gain back even more in percentage terms than it had lost, just to restore the original value of your capital.

The difficulty is that the only way to avoid volatility in long-term investing is by staying out of the equity market, which carries its own share of woes in the form of inflation risk (your capital value being eroded by inflation) and taxes (the higher tax rate applicable to non-dividend income).

The other problem is that avoiding equities implies that you will know when to enter and exit the market, more commonly known as market timing. However, no-one has ever been able to time the market successfully – the skill simply does not exist.

In fact, in attempting to time the market, you are far more likely to create your own form of volatility through entering and exiting at a single point of entry or price point. This could prove far more detrimental to your long-term investment outcome than riding out the intervening market movements.

Rendering investment risk asymmetric

Instead, the key to successful risk management in investing is to reduce the downward impact of volatility to a much greater extent than you sacrifice any upside, counterbalancing the asymmetry of volatility through asymmetrising the risk in your portfolio.

Asymmetrising investment risk requires thinking beyond simple diversification utilising traditional asset classes, such as bonds and cash, to introducing alternative asset classes such as hedge funds and protected equity into portfolios in order to smooth volatility.

The introduction of both local and offshore protected equity and hedge funds as protective instruments into the growth component of portfolios acts to reduce risk and enables the continued compounding of returns even when equity markets are down.

These asset classes generally underperform equities when markets are running, but outperform significantly when markets drop off, ensuring that investors reach the same general destination as equities but with less risk – taking the highway rather than the scenic route through every market hill and valley.

This is not to say that the returns generated by hedge funds and protected equity are uncorrelated, but while they may follow the same general trend as equity markets, their correlation is low.

Consider the below example comparing the Citadel SA Protected Equity H4 Fund’s performance to the JSE Top 40 Index in the year to 30 October 2019.

Past performance is no guarantee of future returns, but these graphs demonstrate the lower levels of volatility and smoothing effect afforded by protected equity in turbulent market conditions. The Citadel SA Protected Equity H4 Fund did not share in the same levels of market euphoria seen in April for instance, yet it still more than doubled the performance of cash (before tax even) in that month. When a global risk-off environment saw the JSE come under some pressure in the third quarter, the fund really came into its own, offering investors significant protection against downside risk.

This is not to say that investors should choose alternative asset classes over traditional, or favour protected equity and hedge funds over equities as growth assets. Investing is not a beauty pageant – there need not be only one winner.

Instead, the argument is that successful risk management begins with a view not only regarding tactical shifts in asset allocation, but also to the types of and quality of asset classes employed within your investment arsenal over time. And this why professional financial advice is crucial – successful investing begins with risk management as its primary concern.

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