The biggest portfolio mistakes in 2022
2022 is already shaping up to be a year of major changes in investment markets. Equity valuations are dipping from record levels and bond yields are expected to rise significantly for the first time in years to combat inflation. We’ve been thinking about the impact of these changes on portfolios as they are typically positioned now, and what advisers should do.
YESTERDAY'S WINNERS
It’s very common to find portfolios filled with investments that have done well. Most commonly we see a large concentration of growth equity funds. Delving deeper with clients we find one of two reasons for this. The first is simply that portfolios haven’t been fully rebalanced, either because of time constraints around reviews or because the adviser is reluctant to recommend that the client realises some capital gains.
The second reason is usually that the adviser is selecting funds based largely on historical performance either by deliberately choosing the best performing funds or by ruling out funds that have underperformed in recent years.
The problem is that funds that have done well tend to have common exposures. Within equities, funds that are heavily-overweight technology stocks and consumer cyclical names with high valuations and long-term growth expectations have done extremely well over recent years. So the resulting portfolio, even if it contains several funds in each asset class, is actually much less diversified than it first appears and therefore is at greater risk of downturns due to market shocks.
And we’ve seen increasing divergence between the valuation of growth stocks and value stocks. The valuation gap is at levels that we haven’t seen since the later stages of the tech bubble, and the current valuations of growth stocks price in a large amount of sustained future growth. We estimate that there are 40 stocks in the ASX 200 that must at least triple their earnings over the next 10 years in order to deliver a modest return of 7% per annum to investors, so high is their current initial valuation.
It’s possible for companies to enjoy growth that fast for that long, but it’s very rare and almost impossible to believe that a fifth of the market will achieve this. And we’ve already seen these stocks fall significantly as the prospect of higher interest rates caused many in the market to revaluate their long term valuation estimates of these stocks.
On the fixed income side, we see many portfolios where the allocations to credit, particularly the more speculative grades, have become much higher than the strategic target due to low returns on safer fixed income investments. Many of these funds have done very well, but with central banks around the world pointing to a rise in interest rates, credit spreads at historically tight levels, falling fiscal stimulus and bad debt charges at historic lows, it’s very hard to see where additional good news could come from to propel the valuation of these investments even higher.
Therefore we’re recommending that advisers reorient their equity allocations toward value and select growth managers that are not heavily exposed to the most richly valued concept stocks. We’re also underweight fixed income, particularly credit, and overweight cash. We’re anticipating that we’ll put some of that cash to work in the next few months as interest rates rise and fixed income becomes more attractive again.
STRETCHING THE STRATEGY
The last few months have been an uncomfortable time to be an investor. Fiscal and monetary support have kept growth high and propelled asset prices to new levels even though inflation and COVID threatened economies and markets.
Many investors have responded to this by deviating from their strategy. For example, we often see many portfolios where the investor has been nervous about markets and their adviser has ended up recommending that only part of their strategic asset allocation be fully implemented.
While it’s understandable that investors would be concerned about risk it’s unwise to deviate from your agreed investment strategy unless there has been a dramatic change in the clients’ personal circumstances. A good investment strategy should adapt to the changing economic environment but do so within controlled limits and a well-established process. This helps protect against behavioural biases, and also manage compliance risks around the implementation of portfolios.
To put it more simply, if you’ve already adjusted your model portfolio’s investment selection to avoid the least attractive segments of an asset class and tilted your asset allocation towards the more attractive markets on offer, you will be taking a disproportionate risk by abandoning that process at the implementation stage and omitting part of the portfolio entirely.
Previously we’ve studied the performance of 3,000 implemented portfolios across a dealer group over 10 years and we found that those investors that were closest to the model portfolio experienced 82 basis points per annum higher returns and around 10% lower risk than those that were furthest away from the model.
The biggest difference between these groups was that the ones furthest from the model portfolio omitted certain investments in the model portfolio. The reality is that timing markets is extremely difficult to do reliably and a well-diversified portfolio that takes moderate tilts based on a disciplined investment process is likely to outperform an approach that chops and changes investments based on emotion and the whims of investors.
KEEPING UP WITH MANAGED ACCOUNTS
The increasing compliance burden on advisers is a fact of life. But an unintended consequence is the increasing amount of paperwork that needs to be kept for every portfolio change or piece of advice is that reviews become less frequent, and portfolios can drift further and are less responsive to markets. A common theme across advisers is that review cycles are stretching out and that their clients’ portfolios are diverging more and more, which only makes reviews more time consuming.
This problem doesn’t only affect advisers. Many institutional multi-managers and asset consultants operate under a calendar cycle, with portfolios updated at investment committee meetings that occur once a quarter. And strict governance regimes often mean that papers for committees need to be submitted at least four weeks in advance. So it could take up to four months for portfolios to be updated. Fund research ratings can be even slower: most ratings houses have an annual review cycle for each fund.
This obviously limits how effective an investment strategy can be, but the shift to passive investments means that the impact of drift on portfolios will be more severe than in years gone by when most investors had active managers adapting the underlying exposures of the portfolio. And when a client asks ‘why are you recommending this change now when the event happened months ago?’ most advisers don’t want to respond with ‘because I only have time to look at your portfolio once a quarter and my research providers take up to a year to update their views’.
As we’re currently seeing the first significant inflation in developed markets in many years, changes in interest rates throughout 2022 are likely to cause profound shocks in investment markets. We’ve outlined a few of the possible implications above, but we suspect that any repricing will happen quite quickly.
Studies show that a three month delay in implementing changes would waste about 80% of the value added by those changes, and the value-add is greatest at times of market dislocations like those that we’re expecting over the next year.
Many advisers are turning towards managed accounts to help manage client portfolios more effectively and reduce their workload. In our study of implemented portfolios we found that the average managed account portfolio was 90% aligned with its target model portfolio while the average manually managed portfolio was only 50% aligned.
It’s simply not possible for an adviser with even a moderately large book of clients to keep all of their portfolios in line with model portfolios through the gyrations of markets given their compliance burden, but managed accounts can respond to markets within hours, and without the need for any Records of Advice (RoAs). This improves portfolio responsiveness, but also allows advisers to engage more with their clients as there will be a consistent narrative across clients.
Advisers we work with have a mix of managed account strategies: some are happy to use an “off the shelf” SMA from a provider they trust, others partner with a group like us to develop a branded or customised managed account program of their own. In some cases this is with a view to eventually moving the management of portfolios in house.
Regardless of the approach taken, we believe that managed accounts should be the default offering for most advised clients. The benefits from improved portfolio implementation, increased use of passive and direct investments and manager fee rebates more than compensate investors for the small additional cost. It is our view that advisers should start moving their clients into managed accounts before market turbulence, rather than waiting until after the event.
Rowan Stewart is joint chief investment officer at Aequitas Investment Partners.
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