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The Four Pillars of HHG's Managed Portfolio Strategy

The last couple of months have been volatile to say the least, and this has naturally presented a lot of challenges for investors. Recent years have seen markets rise in an almost uninterrupted fashion with only a few minor reversals. This has, perhaps, led to some complacency among investors. While markets globally seem to be in a bit of a holding pattern as investors contemplate their next move, HHG believes that now is the time for investors to reassess their strategy and position portfolios for the longer term, so they are protected against further volatility and can capture the eventual recovery. In recent years HHG has made a conscious effort to position managed portfolios in a manner that would protect against a stressed market environment. We have emphasised building robust portfolios that are diversified across asset classes and funds, and not overly exposed to any style or theme. As a result of this clients’ managed portfolios have been somewhat insulated from the broad-based sell-off experienced in markets. Our philosophy remains unchanged and is still relevant, particularly given we are yet to gain clarity on how deep or long this downturn may be. In this article, we highlight the four pillars of our philosophy for managed portfolios — rebalancing, diversification, emphasis on quality, and active management.

1. Rebalancing takes the guess work out of investing
Asset allocation plays a key role in any diversified strategy and for managed portfolios we have reinforced the importance of rebalancing in the current environment. Market timing can be elusive and we have often observed it is darkest just before the dawn. Rebalancing takes the guess work out of investing and ensures we stay the course with our long-term strategy and objectives. Failure to rebalance can threaten the diversification benefits of a portfolio. It is best practice to set limits or ranges around how far the actual asset allocation can drift from the target asset allocation (i.e. tolerance levels). For example, a +/-5% range for an asset class is a reasonable and practical point to commence the rebalancing process without being too reactive. In risk-off environments, portfolios tend to be overweight cash, bonds and alternatives, while underweight equities and credit.

2. Diversification plays a key role in strengthening portfolios
Given the current volatile environment, it is prudent to maintain a diversified portfolio that is not overly dependent upon a particular outcome, which would leave investors exposed to unpredictable risks. While we expect to eventually see a recovery, diversification will continue to play a key role in enhancing the robustness of managed portfolios. From HHG’s perspective, being prudent with asset allocation and having ample exposure to various funds across subasset classes and styles are the key components of diversification. Well diversified managed portfolios should yield better risk-adjusted returns over the long run.

Equities generate long-term growth
As a starting point, HHG would advise that portfolios have adequate exposure to core equities as an anchor strategy. This should then be complemented by high-conviction equities. The key to any strategy, regardless of style, should be a focus on quality. This generally means exposure to businesses with low debt/gearing, high return on equity and low cyclicality.

Should a portfolio not have any exposure to quality equities as its core a review should be initiated as part of any rebalancing effort.

Alternatives can provide uncorrelated exposure to fixed income and equities
Alternatives can provide an uncorrelated/diversifying exposure to bond and equity markets. Being nimble and opportunistic are key elements that this asset class also provides. Generally, alternatives are split into growth and defensive investments.

It is crucial to maintain allocations to both, depending on the risk profile and investment objectives of the portfolio. For those already invested, it is important to stay the course and let these exposures play their role in this environment.

Fixed income acts as a core defensive allocation
Portfolios should have adequate exposure to high-grade bonds as a core defensive allocation. Fixed income remains a conundrum, including the low bond yields on offer across developed markets and the poor value bonds generally offer. However, from a defensive perspective, bonds continue to have a role to play in a diversified portfolio. With no prospect for higher rates in the near future, duration risk is fairly low.

While credit spreads widened in line with the risk-off environment, they have somewhat calmed in response to many central bank interventions. Given the dire economic and corporate earnings picture, parts of the credit market, particularly high yield, remain high risk and should be trimmed where possible.

Bloomberg Barclays US Credit index – historical OAS

3. Active management can provide downside protection
While recent years have presented some challenges, active management is likely to be best suited to an investment universe where idiosyncratic risk and the cost of information is high. Active management tends to outperform in high dispersion markets where security correlation is low. Active management is prudent to help manage potential pitfalls and should be a key part of an investor’s portfolio strategy going forward.

Now also presents a good opportunity to trim passive exposures to risky parts of the market. Having said that, passive strategies can play a role in portfolios, particularly when utilised as a low-cost solution in more predictable parts of an asset class. In practice, this means potentially utilising an exchange-traded fund in equities to gain benchmark-aware exposure to large caps. This would then be complemented by active management in less predictable parts of the market. While this applies to equities, it is less applicable to alternatives and fixed income, where adviser skill is expected to generate the majority of the return and risk has to be managed appropriately.

4. Quality is the key building block in today’s market
HHG continues to emphasisd quality as the key building block in today’s market. While quality is always an important part of any investment strategy, it is even more critical now. This aspect of portfolio strategy ties in with rebalancing, diversification and active management.

Quality versus S&P 500 index during GFC

Through stressed market conditions we have historically seen divergence between quality stocks and the broader index increase. This is shown in the following two charts—firstly through the GFC and now since the onset of the COVID-19 sell-off. This phenomenon is also evident in fixed income markets where instruments from debt-laden sovereigns and companies are out of favour. In this environment, it is imperative to differentiate between assets that have solid fundamentals and those that have a real probability of capital loss. Higher quality credit is significantly outperforming lower quality credit.

Quality versus S&P 500 index during COVID-19

In summary
While valuations of most asset classes have improved in recent months, an expected plunge in economic growth over the short to medium term, and the risk that earnings expectations priced into valuations will not be fulfilled, is still real. At present, there is no clear sight on what the earnings picture will look like going forward. The key is to construct portfolios that can still achieve investors’ objectives over the long term and protect against any further volatility or downside in the short term. HHG believes ample diversification, rebalancing, selectiveness in instrument quality and being opportunistic, along with active management, are the key elements that can deliver on a portfolio’s long-term objectives.

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