If the near 6.6% drop in the Aussie market since the start of the year (as at cob on 27 January 2016) hasn’t already spurred you into action, now’s the time to ask some hard questions. Will your portfolio withstand another year of volatility and potential market shocks? Is it too heavily weighted towards resources and financials?
We all know the past two years have delivered mediocre returns and substantial volatility. The major drivers of this have hardly abated and with an increased focus on, and uncertainty over, US policy rates, we can expect more of the same this year.
Events since the start of 2016 characterise our outlook for global markets – lacklustre growth and risks skewed to the downside, likely fuelling bouts of investor uncertainty and volatility.
As investment horizons shorten, people’s tolerance for risk generally declines as well, particularly as they approach retirement. Managing volatility is important to investors, who are thinking about their financial needs without regular income, especially when they start to withdraw income from their investments to fund retirement.
Portfolios can suffer significant losses during crisis events and can take longer than expected to recover. For example, an investment portfolio that loses 10% of its value requires an 11.1% return to break even over a one-year period. A portfolio that loses 30% of its value requires a 42.9% return to recover. Losing less by reducing downside risk therefore is a winning strategy, in my opinion.
Many portfolios are constructed largely around benchmarks, such as the S&P/ASX 200 Index, whose market cap is dominated by financial and commodity-related shares. This approach has its benefits, namely that the goal posts for return and risk are limited around benchmark outcomes, but it also leaves investors vulnerable to risks from major movements. The upside is limited relative to the benchmark return, while the downside is similar and can exceed market sell offs.
So how do you manage this volatility and add value to your portfolio over the coming year? My firm belief is that it’s worth adopting a truly active mindset and ignoring benchmark weightings.
Financial and commodity-related sectors were a significant drag on risk-adjusted index returns over the past year and I believe they’ll continue to add volatility and may depress returns for the year to come.
But while the financial sector faces headwinds, and I believe its weighting in the index is inappropriately high, of greater concern are mining and energy stocks. It’s a struggle to see strong drivers of change for the commodity and resource complex and as such, I’m wary about investing in them. While these sectors may spike during sharp risk rallies, I don’t believe the current weak earnings outlook and high volatility make for attractive investments.
Yes they may look cheap, but buying into them now requires a belief that economic fundamentals are improving – a belief I don’t share. While they may well be nearing the bottom, there’s no imminent catalyst for improvement.
I believe that more reliable returns in 2016 will be delivered by high quality companies with stable earnings, cash generation and moderate growth, well beyond the familiar territory of the Twenty Leaders. Some of these stocks can be found in the healthcare, utilities and consumer discretionary sectors. You may have to pay up for this quality, but I believe it’s worth taking this risk.
Olivia Engel is head of active quantitative equity, Asia Pacific at State Street Global Advisors
Important: This content has been prepared without taking account of the objectives, financial situation or needs of any particular individual. It does not constitute formal advice. Consider the appropriateness of the information in regards to your circumstances.
