Michael Blayney: why a diversified portfolio is crucial right now

 

Investors with well-diversified, well-designed portfolios should stay the course amid the COVID-19 volatility, says Pendal Head of Multi-Asset Michael Blayney.

Michael explains why in this short video. Or read the transcript below.

 

 

Transcript

I’m going to provide you here with a brief update on our views on portfolio construction and current market conditions in light of the COVID-19 related volatility we are experiencing.

The first point is it’s always important to maintain a diversified portfolio and there’s multiple ways in which people can diversify their portfolios at a basic level.

It’s having both equities and bonds — but also within equities it’s having a blend of Australian and global equities.

Even though they might move together on a day-to day basis, over an investment time horizon of a balanced investor — which would be five years or more — they can provide substantially different returns over those longer-term time horizons.

In addition, it helps in a portfolio to have some alternative assets and also some foreign currency exposure.

The foreign currency exposure is usually achieved by holding a reasonable proportion of the global equities on an unhedged basis.

In the first part of the recent market correction that we have had, we saw that bonds provided nice diversification to equities with yields falling at the same time that equity markets were falling, resulting in capital gains for government bonds.

In the most recent leg of the market sell-off, we have, however, seen bonds and equities providing negative returns at the same time.

Now the key thing about portfolio diversifiers is they don’t necessarily always diversify in every market condition, so it’s important to have more of them.

And that’s why, for example, foreign currency has been extremely valuable — because the Australian dollar has continued to depreciate and this has helped to cushion the portfolio.

In addition, alternative assets can provide a degree of portfolio diversification as well.

We’ve seen mixed performance from alternative assets in the large selloff that we’ve had. However, even when negative returns have been achieved by the alternative assets, they have generally been better than equities.

So if you put together a portfolio of equities, bonds, alternatives and some foreign currency, that has smoothed the path of returns — even if they’re still negative for an investor.

Spreads on corporate bonds

We also note that in the current environment spreads on corporate bonds — which are essentially the excess yield that a corporate needs to pay to borrow in excess of the government — have widened quite a lot.

We now have spreads in investment-grade bonds, if you look at the US corporate index, of approximately 285 basis points. High-yield spreads also widened considerably.

If we look at the long history of investment-grade bonds, even through world wars, depressions, recessions and financial crises, default rates on investment-grade bonds tend to be very, very low.

So the spread that you get on investment-grade bonds is largely compensating you for what your liquidity is.

That’s a big part of the reason why spreads have blown out so much now.

While we may see some defaults come through, particularly in the energy and leisure sectors, the current buffer on offer on investment-grade bonds well and truly compensates for even an adverse default cycle.

If we were to, however, look at high-yield bonds, the default cycles there can be significantly worse.

And if we see significant defaults on energy, which represents a reasonable proportion of the high yield market, then the current spreads on offer might not be sufficient to compensate for that.

So we’d prefer investment-grade exposure in this environment.

Long-term valuations

While earnings and dividends will take a hit, the current market reaction has exceeded where we believe the impact on long-term valuations should be.

We think it’s probably about about double that impact.

Of course coming into this some markets were very expensive, for example the US. Whereas a lot of the Asian markets were already actually reasonably undervalued.

So some of those markets do represent extremely good value in the current market environment.

In addition, once the crisis eases somewhat and investors start to look around for ways in which they can generate returns on their assets, a quarter of a per cent official cash rate would most likely not be a particularly attractive return.

Even though we are likely to see dividends get cut on shares, the dividend yield on shares is likely to be significantly better than that very low cash rate.

Yields on corporate bonds — in particular investment-grade given those blowouts and spreads — are also likely to become attractive to investers again.

As a result, we believe that in this environment investors should stay diversified, increase exposure where appropriate to particular circumstances of a portfolio, and very much stay the course and do not panic.

We know that while it’s impossible for anyone to predict the exact bottom of a share market, if people do bail out after very large falls, that tends to be quite destructive to long-term wealth.

We know it’s far better to stay the course with a well-diversified and well-designed investment strategy.

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