By Guy Fletcher, head of Research & Client Solutions at Sanlam Investments
Ray Dalio, the billionaire founder of Bridgewater Associates, describes his epiphany when he discovered the “Holy Grail of Investing” as something akin to what Einstein must have felt when he discovered E=mc2. Dalio’s Holy Grail can be simply described as the discovery that, with 15 to 20 good, uncorrelated return streams, you can dramatically reduce risks without reducing expected returns. And knowing how to combine these return streams is even more effective than being able to choose the good ones, although that clearly helps too!
Combining asset classes (or return streams) is the very basis of portfolio construction. The way these asset classes have historically correlated, and are expected to correlate in future, is, however, a multi-faceted problem. It requires insights into the economic environment and the business cycle, as well as the mechanisms of price formation e.g. company profitability, cash flows to support debt payments and interest rates. These insights are ably covered by a veritable forest of economists, analysts and portfolio managers. But the key to building the best sustainable strategy is always diversification, and to build a fully diversified strategy one requires significant breadth of both asset classes and investment styles, and the understanding of how to combine them.
The average investor has a general awareness of traditional asset categories, namely equities, property, bonds and cash, both in a domestic and international context. However, as the search for additional sources of return has become obligatory, the use of alternatives has become more prominent. Alternatives are generally represented to include hedge funds, private equity, private debt, commodities and unlisted property, and clearly expand asset class options. But one needs to understand price formation in each of these asset classes. For example, when asset valuations are undertaken on a quarterly rather than daily basis (typical for unlisted vehicles), relative risk is significantly understated. In a similar vein, alternatives tend to have restrictive conditions (e.g. lock-in periods) that must be adjusted for when comparing them to traditional assets. These aspects change our expectations when we have a need for high levels of liquidity. However, if we are able to stay the course, alternatives can provide significant advantages by allowing the long-term investor to access this illiquidity premium.
Styles are a different mechanism of diversification; it is not about which style is best e.g. passive or active, value or growth, factors or indices, but rather which combination is best suited to each client’s goals and requirements. By way of example, we regularly hear that value is the style that is most likely to yield the highest long-term return. However, value is a long-cycle style implying that returns may take a long time to eventuate. If a client’s portfolio is one that requires high cash flows, a value style alone may create a sub-optimal result. Introducing a short-cycle style such as momentum diversifies the return, lowers risk and delivers greater consistency. Selecting and combining independent styles have become a new form of active.
Portfolio construction is a disciplined, personalised process. In constructing a portfolio, the individual risk and return characteristics of the underlying investments must be considered along with the client’s unique needs, goals and risk considerations. The recommended approach to portfolio construction is based on delivering a solution that takes advantage of access to multiple styles across multiple assets. It provides the asset manager with the capacity to deliver a far greater probability of uncorrelated return streams and hence, the ability to deliver expected returns at a lower risk.
We are currently engaged in new, exciting and applied areas of work within these disciplines and look forward to sharing our work and experiences that create new epiphanies.