Many investors thought they were adequately diversified in 2008, only to see their portfolios collapse during the great financial crisis (GFC). “Modern Portfolio Theory did not fail – if anything, portfolio construction did,” says Professor Christopher Geczy, academic director of the Wharton Wealth Management Initiative, in a research note by BlackRock.
He says what really happened back then, was that many investors did not have the right investments in their portfolios.
“Portfolio construction is challenging enough to begin with, and it’s even harder during times of crisis, when correlations can work against investors.”
Turning to the present, the crisis of the current market collapse across various asset classes has demonstrated some level of correlation among most of them. For example, many investors believed that merely having exposure to both JSE-listed and international stocks provided sufficient diversification, but the stocks turned out to be exposed to many of the same common factors, such as the price of oil.
“There is no doubt that global capital flows will be impacted by Covid-19. The collapse in oil and other commodity prices has also resulted in a revised downgrade in global growth expectations and asset prices,” says Sumaya Aziz, investment analyst at Mergence Investment Managers.
According to Geczy, a traditional 60% stock and 40% bond portfolio would undoubtedly fare better during a market crisis than a 100% stock portfolio but, given high levels of correlation, it’s becoming hard for investors to rely on what is traditionally thought of as diversification to meet their long-term goals.
He says investors need to rethink their overall approach to portfolio construction and start thinking in terms of risk diversification and getting exposure to as many different and non-correlated types of risk as they can, which brings us to alternative investments.
The concept of alternative investing is about going beyond what a traditional 60-40 portfolio might look like by either going long on assets that are not already present or by engaging in trades that provide a new source of diversification.
Alternative investments are core diversifiers, sources of potential return and investments that provide risk exposures that, by their very nature, have a low correlation to something else in an investor’s portfolio, says Geczy.
Real estate and infrastructure
Real estate funds pool money from long-term investors such as institutional pension and provident funds, retirement funds and multi-managers.
The market is small relative to the real estate investment trusts (Reits) listed on the JSE, according to Smital Rambhai, portfolio manager of Futuregrowth Community Property Composite – a portfolio specialising in the acquisition of new and existing shopping centres that cater to the needs of underserviced communities throughout SA, mostly rural and township areas.
Real estate funds have a longer-term outlook than Reits as they are not required to distribute incometo investors, says Rambhai. “Reits have to distribute a minimum 75% of cash income earned to maintain their Reit status. The management teams of real estate funds are therefore able to take longer-term views on property assets as they have cash available to reinvest in their properties to maintain and uplift value for investors over the longer term.”
According to Rambhai, these funds tend to offer long-term, stable financial returns that have less volatility and a low correlation to other asset classes. They have real, hard assets with diversification benefits, a rental income stream that is a hedge against inflation and have access to a segment of the property market that the Reits may not be focusing on. He says the value of the investment is not sentiment-driven, but rather based on actual income generated and the capital appreciation of the asset.
Nevertheless, such funds have some pitfalls. Liquidity constraints are a critical factor in real estate funds, for instance.The managers of real estate funds need to utilise either cash flows that are generated from the properties or sell a property to pay investors seeking to disinvest. Corporate governance is of utmost importance, says Rambhai, as “weak governance controls can result in poor decisions being made that will impact investor returns”.
Both financial and non-financial factors such as environmental, social and governance are considered when Futuregrowth decides to buy, develop and manage existing properties – and could thus be deemed impact investing. The social benefits that accrue from such developments include creating employment before and after construction, providing access to key retailers and reducing transport costs for the community due to the shopping centre’s proximity to transport and services.
In a social context, physical infrastructure is the backbone of a country and the economy, says Mergence’s Aziz. “The country’s basic infrastructure and services require bolstering through accelerated investment into electricity generation, building, upgrading and ensuring the efficient operation of state hospitals, and laying down the foundations for a quality education system, facilitating access to all.
“Infrastructure assets provide investors with relatively stable cash flows akin to fixed-income instruments, which should drive the pace of investment. The cash flow profile is also naturally inflation-hedged.”
This is a shortened version of an article that originally appeared in the 4 June issue of finweek. To read the complete guide on alternative investments, you can buy and download the magazine here.