Clients and their advisers may have had to reconsider their portfolio construction over the past year, as some of the strongest performing stocks have declined sharply.
While a rotation away from some of the large technology stocks had long been expected, the scale of the sell-off may have taken many by surprise, and the anticipated rise in the more cyclical areas of the market happened, but only briefly, as concerns about the outlook for global growth spooked investors.
So, amid such uncertainty, what does a diversified equity portfolio look like?
Global funds best way to gain equity exposure
The majority of advisers believe the best way to achieve diversification from equities is through owning global funds, according to the latest FTAdviser Despatches poll.
The poll, which asked advisers “Are global equity funds the best way to get equity exposure?”, saw 75 per cent of respondents saying yes and 25 per cent saying no.
Global equity funds have been the biggest sellers in the Investment Association equity universe for the past four consecutive years, a time period in which there have been extensive outflows from the UK equity sectors in particular.
Amid the highly unusual market conditions of the past decade, asset allocation within equities has been acutely difficult, perhaps increasing the appeal of global equity funds, which enable the investor to effectively outsource the asset allocation to a third party.
It has also been a noticeable feature of the market this year to date that global equity income funds, arguably sometimes a forgotten part of the market, have seen inflows at the expense of UK equity income funds, which were once a huge part of the UK client’s portfolio.
Building a global equity portfolio in turbulent times
Investing during turbulent times highlights the principle of diversification, including across sectors and regions, and also calls into question previous assumptions made by many investors and their clients.
Many bull markets are driven by the notion that 'it is different this time', while the turbulence that follows can act as a reminder that those are often the four most dangerous words in the market.
Over the past few months, volatility in global equity markets has been extreme, says Federated Hermes global equities portfolio manager Louise Dudley, citing inflation and the pandemic among a range of issues.
“There are clearly many risks for investors at the moment, as macroeconomic concerns stemming from aggressive monetary tightening, the Russia-Ukraine conflict and China’s stringent Covid lockdowns persist,” says Dudley.
“Volatility is therefore likely to remain high, so maintaining a diversified portfolio will be crucial to navigate these turbulent market conditions successfully.”
But with countries besides the UK facing inflation, what might a global equity portfolio during turbulent times look like?
“Critical to portfolio management in any time, but particularly in turbulent times, is the appreciation of not just the exposures you want to have, but also the ones you do have but might not want,” says Nomura Global High Conviction fund manager Tom Wildgoose.
“This is particularly the case for bottom-up stock-pickers who might invest in several individual stocks, only to find that they all have an outsized exposure to a certain macro issue, such as a certain region or commodity.”
With a strategy to diversify investments in well-managed, quality businesses operating globally rather than domestic-oriented ones, Gerrit Smit, head of equity management at Stonehage Fleming, says: “Those management teams understand the opportunities and risks better, and we do not need to take direct currency and domestic market volatility risks, but can share in the operational successes on an indirect basis.
"For example, we have no direct exposure to China, but have excellent exposure to their high potential consumer market through global operators.”
Contractionary monetary policy
As attention shifted from the pandemic to inflation, Nigel Bolton, co-chief investment officer at BlackRock Fundamental Equities, describes a global economy “pumped full of money” when central banks and governments responded to Covid.
“Much of that money ended up in equity markets. As central banks now seek to tame inflation and withdraw excess liquidity from the system, we expect continued stock market volatility throughout the year. This calls for a focus on resilient business models."
Bolton adds: “Where can we find these resilient businesses? Europe is home to many quality, best-in-class companies that are well placed to enable long-term, structural shifts such as digitalisation and the transition to a net-zero economy.”
Agreeing that equity markets have generally been “highly supported” by central banks’ actions over the past decade, Amati Strategic Innovation fund manager Graeme Bencke says there is progress towards more "normal" monetary policy, bringing valuations back into focus.
In June the Federal Reserve raised its benchmark policy rate by 0.75 percentage points, while the Bank of England increased bank rate by 0.25 percentage points.
“Analysts are likely to be more discerning regarding the profitability and cash generation of companies, which bodes well for fundamental investors,” Bencke adds.
Near-term concerns around the economy and supply chain disruptions are understandable, but temporary
Steve Wreford, a portfolio manager on the global thematic equity team at Lazard Asset Management, also speaks of the opportunity that volatility presents for long-term investors.
“The market is a great teacher and the lesson being taught today is that investors have to anchor to something other than current share prices. Being led by price means being led by emotion.
“The alternate path, the correct one, is to stick to your process and be patient. In our case, we anchor to what we believe will be strong long-term themes and stocks trading at reasonable valuations – a combination that will leave us well-positioned for when the turbulence subsides.
Even in periods of market stress, Leslie Alba, associate director of research at Morningstar Investment Management, finds that asset classes trading below their fair or intrinsic value have a margin of safety, and are likely to fare better over the full cycle.
Aviva Investors global equities manager Richard Saldanha also thinks investors need to focus on fundamentals.
“Amidst the volatility, we are seeing some real dislocations emerging between underlying fundamentals and share prices, which ultimately we believe presents an opportunity. Investors need to hold their nerve right now given there is a lot of noise out there,” he says.
Indeed, investors have been in ‘risk-off’ mode for much of the year, says Canada Life Asset Management senior fund manager Bimal Patel. “During this time investors have been avoiding loss-making companies, and companies that do not have the free cash flow to make it through the economic slowdown.”
But Patel also warns that whether a company appears profitable can depend on accounting standards.
“For years investors have turned away from generally accepted accounting principles, having been seduced by companies into using non-GAAP measures, which leniently exclude stock-based compensation that can be a significant non-cash cost.
“The inclination to continue to use non-GAAP metrics has evaporated. It can be the difference between profit and loss, a company can be profitable using non-GAAP reporting while being unprofitable on GAAP reporting. Earnings models are being repopulated with GAAP metrics, though perhaps this is only a temporary precaution for risk-off periods.”
J Stern & Co chief investment officer Christopher Rossbach agrees fundamentals are most important.
“We believe that investment decisions should be formed by focusing on what companies are doing and the opportunities they are seeing, rather than being swayed by macroeconomic conditions.
“Despite the increasing pressures, we continue to believe that if a company can show it has the pricing power to offset inflation and the innovation to grow volumes, it will be well-positioned for what comes next.”
Going against the general perception that tech companies and other disruptive businesses are the only real source of robust and growing cash flows, Orbis director Ben Preston says some more “mundane” businesses warrant another look.
“And not just from a value perspective, but on the strength of their fundamentals as well. Many are now in a position to return significant cash to shareholders, have very healthy balance sheets and are trading at vastly lower multiples than the stock market darlings of recent years.”
Aviva Investors’ Saldanha adds that investors should remain focused on areas with clear long-term structural drivers, citing energy efficiency and industrial automation as some examples.
George Dent, an investment manager at Walter Scott, which manages the BNY Mellon Long Term Global Equity fund, says structural growth drivers such as in the healthcare and technology sectors remain an important part of what companies will need to weather a potentially challenging economic environment over the next 12 to 24 months.
“Importantly, this growth needs to be paired with the kind of quality characteristics that will help companies tackle a higher inflation, higher rate environment, specifically superior profitability, pricing power and strong balance sheets.”
Buying the dip
Meanwhile in the short term, Canaccord Genuity Global Equity fund manager Sid Chand Lall says inflation concerns may enable an underlying portfolio manager to invest in sectors such as utilities, for example water companies where dividends can grow in line with CPI, and premium brands where input costs are easily passed onto the customer.
Redwheel's head of global equity income Nick Clay also sees opportunity in luxury retail.
“Volatility will present opportunities in companies still perceived as cyclical but that are structurally more resilient than feared, such as luxury retail like Richemont, Kering and Tapestry or semiconductor companies such as Qualcomm, TSMC and Samsung.
“Such companies have the required pricing power, dominant market positioning and have far less cyclical end markets than the economy as a whole.”
When it comes to opportunities, stick to what you know.
At the opposite end of luxury goods, Royal London Global Equity Income fund manager Niko de Walden is “shying away” from crowded sectors such as consumer staples.
“[They] make for great hiding places for the fearful, but in our view offer overvalued long-term wealth creation given their general struggle to organically compound cash flows long term.”
Ben Leyland, senior fund manager at JO Hambro Capital Management, also suggests avoiding crowded trades. "Turbulence is magnified by liquidity evaporating at times when everyone is trying to reposition their portfolios in the same way at the same time."
Leyland proposes looking for high-quality businesses with inherent inflation protection, such as payments businesses and regulated utilities, but says: “When it comes to opportunities, stick to what you know.
“This is not a time to go out on a limb and take on risks you don’t understand. If you buy something as a hedge or trade you will be unprepared to weather ongoing volatility. Think strategically, not tactically, and focus on where you have genuine long-term conviction.”
Indeed, River and Mercantile UK equity investor William Lough says recent events have not changed his approach.
“We maintain the same philosophy and process of looking for a combination of potential, valuation and timing in each of our investments.
"But I am more committed than ever to slow down the tempo, avoid thrashing around by responding to the latest news headline or macro datapoint, and to really focus on the long-term prospects for our investee companies."
Lough adds: “There are so many conflicting stories, datapoints and viewpoints currently that it’s easy to be whipsawed, so at times like this you have to focus on what you are good at and how you build conviction in your investments. For me, that’s by going bottom up, case by case.”
Amid rising input costs, inflation and muted economic growth, Dudding emphasises that focusing on quality should be ever more important.
Hannah Gooch-Peters, a global equity investment analyst at Sanlam Investments, agrees: “During the disparate market environments witnessed since the pandemic first struck, we have continued to believe that it has been more important than ever at this point in the business cycle to focus on high-quality companies with the ability to demonstrate long-term, consistent earnings growth, the ability to reinvest cash flows at high returns on capital, and strong balance sheet strength, while maintaining our valuation discipline.”
While the ideal is buying at the bottom of the market in an uncertain environment, Lall at Canaccord Genuity adds that few ever can or do.
“Rather than try to market-time the investment, it is perhaps better to buy in very gradually across a cycle, whether that be monthly or quarterly to get a more efficient average cost price. Although you won’t get the absolute bottom, you won’t pay the absolute top either.”
Chloe Cheung is senior features writer at FTAdviser
Picking the right global equity fund
The largest sector within the Investment Association by funds under management is Global, with £175.6bn AUM as at the end of April. Perhaps not surprising, for the past four years it has been the best-selling sector for retail investors.
These funds, by definition, must have at least 80 per cent of their assets in equities and diversified by geographic region. That should make them a useful core component of a portfolio and perhaps even a one-stop solution for the smaller client.
For bigger portfolios you may choose to hold more than one fund. The challenge is choosing the right one or the right ones.
Holding similar funds does not diversify risk
A friend showed me his portfolio recently. I am not qualified to offer financial advice so I was careful not to make any recommendations other than to point out that, though his portfolio is less than £500,000, he owns 11 global funds. I was surprised to see so many. Advisers who regularly come across DIY investors’ portfolios may not be.
At the other end of the spectrum, institutional investors take a much more deliberate approach to building portfolios. What things matter most to them in fund selection?
What do professional investors look for?
An institutional investor will want at least a three-year record and preferably 10 so they can judge your performance during difficult periods. Has the fund manager just been lucky? Luck tends to even out over the long term.
There are several ways to measure this, and the data is readily available. The information ratio measures a fund’s return against that of a relevant benchmark, like the MSCI All Countries World Index. The Sharpe ratio does the same against a risk-free rate based on government bonds. In both cases a higher number is better.
Beta shows the fund's volatility in relation to the overall market. A beta of less than one indicates it is less risky than the market, and the reverse applies if it is greater than one.
Volatility is important if you are an adviser. Clients can quickly forget strong outperformance if their holding has lost 30 per cent in a year, particularly if a period of poor performance coincides with a review meeting.
Understanding the drivers of diversification
Some managers are conviction managers – I did some analysis of my friend’s portfolios and found three with more than half their assets in just 10 stocks, and one with more than 60 per cent. That only works when your calls are right. Can you take that risk for your clients?
We would have less than a quarter of our portfolio in the top 10, on the basis that with a global mandate we can find plenty of good stocks without having to take so much individual company risk.
Professionals look at our exposure to sectors, too. Fund selectors will be careful that they are not enhancing correlation risk by, for example, blending two global funds with heavy exposure to consumer retail.
We build our portfolios around secular investment themes such as automation, low-carbon world and healthcare costs. We work hard to ensure that these are not overly correlated with each other. That should make it easier to plug our fund alongside another without increasing correlation risks.
An obvious and common question is how global are we compared with, for example, the MSCI ACWI? You would expect some mismatch – our job is to take calls on which regions we should overweight. But at least one of my friend’s funds was virtually all focused on North America and Europe.
Exposure to the UK is an important issue, too. Another fund had 33 per cent in the UK, and four had more than 20 per cent (we have around 3 per cent). If your client holds UK funds separately, the addition of a global fund may simply be reinforcing their home bias.
An institutional investor will avoid smaller funds; they fear holding too big a proportion of the fund, as this can make it difficult to exit. Individual investors do not have that problem, but fixed costs can be a drag if a fund is too small.
But can a global fund be too big?
When I choose a company for our funds I have a simple rule of thumb: I should be able to build my holding in a week and be responsible for no more than a third of that company’s stock traded that week. Liquidity is a constant concern. What takes you a week to buy in normal markets might take four times that to sell during a market correction.
Running a large-cap fund under £1bn, I have plenty of choices. If I was a large fund buying £500mn worth of stock in a week, it would limit my opportunity set to mega-caps, reducing the opportunity set for outperformance.
How important is ESG to your client?
All requests for proposals (RFPs in the lingo of the trade) now include questions about sustainability. As an adviser, you have the challenge of aligning your client’s preferences with that of the funds you choose. None of my friend’s portfolio had 'ESG' or ‘sustainable’ in its title, but I know several are as principled as we are in their stock selection.
We will not invest in fossil fuels, munitions, tobacco or in areas of poor governance. We think this ‘do no harm’ approach broadly covers what our investors want, but your clients may feel this does not go far enough. Morningstar ratings help, but as an adviser you may have to dig further to ensure you are matching your client with the right fund.
Understanding each fund managers approach
My friend’s portfolio illustrated the huge range of funds in this sector. Beyond the features already mentioned, his portfolio included recovery funds, a tech growth fund and a couple focused on smaller companies.
The distinguishing feature of others was the approach of the manager – buy and hold, for example. That sounds good when the world is constant, but at times like this may not be so appealing.
Our position has been to build a core portfolio that meets the needs of most investors and their advisers. Its aim is to outperform the market in down periods, capture a lot of the upside, and do so in a principled way. It is not to everyone’s taste, but we hope it is to most people’s.
Alex Illingworth is co-manager of the Mid Wynd International Investment Trust and the Artemis Global Select Fund
All photo credits: Pexels
All photo credits: Pexels