Investment Diversification During Uncertain Times

Stock market investors have certainly endured a rocky time in recent months and views are divided over what will happen next. Everyone is trying to time the market and talk about the best principles for investing going forward.

A common argument that comes up time and again, especially in difficult markets, is the one about active versus passive investing.

A common argument that comes up time and again, especially in difficult markets, is the one about active versus passive investing. Both sides have an opinion and can argue passionately in favour of why their particular form of investment works best, and how best to find sunken gold. Of course you could always invest in real treasure hunters, like the US based firm which last year recovered 500,000 gold and silver coins weighing 17 tonnes from the Nuestra Señora de las Mercedes, otherwise know as the “Black Swan”. But it’s worth bearing in mind that the ship it was recovered from did however sink around early October 1804. While it’s true that fantastic rewards can await those with patience and a keen eye for diversification, waiting over 200 years for a return could try even the most sanguine of investors.

What kind of investment house will benefit during the current turmoil?

The most likely candidates are companies with a full product range, which are at an advantage in what they can offer. When it comes to the debate about active verses passive investing, it’s a bit like podium politics – you know both sides have to take an entrenched position, partly for appearances, and there is usually a third way.

International Investment - Passive performance

Passive managers generally believe that it is difficult to beat the market. Therefore, they essentially offer asset class performance that closely matches an index for those investors who are unwilling to assume the risks of active management. Active managers believe the market can be beaten. While they can't beat it all the time, many active managers do believe there are certain irregularities in the market that can be taken into consideration to achieve potentially higher returns.

What about a little bit of both and a heap of diversification?

Looking at the Bloomberg screen, it is clear that index trackers and passive funds are not having a happy time at present, as indices continue to revisit bear-market lows. Conversely, it is active funds which suffer most from investor tantrums in a rising bull market - finding themselves subject to questioning of why one should pay for performance when the market is going up very nicely, thank you. This point is raised in every bull market, but it is that same group of investors who are often conspicuously silent later on as the investment seas become more choppy. Passive funds are often referred to as “building blocks” on which the rest of an investment portfolio can be based.

International Investment - Active Management

It should be noted, however, that passive funds are not and never should be a sole, stand alone investment. Especially not, when faced with trying to preserve capital and the somewhat depressing sight of a falling market. This is particularly pertinent when we find ourselves watching the building blocks of passive investing plummet downwards, as promised, in perfect correlation with their benchmark indices.

As the prospect of a protracted economic slowdown becomes more likely, we may well see the focus turn once more to active management. With the relative outperformance of active to passive, passive investors may find themselves rethinking their exposure to indices and start looking more at active approaches. For example the last bear market offered several hiding places for active managers in defensive stocks and as these same islands of defensive stocks were already going cheaply they did not have much room to head further down. This time around the sheer breadth of the market fall means there are very few hiding places for the long-only manager.

International Investment - Diversification

Diversification, then, becomes paramount and the focus turns increasingly to, not just the active manager in general, but to those managers who are capable of producing returns regardless of the market cycle. These managers tend to be those who incorporate specialist investment mandates, whether that is active investment or enhanced indexing, an absolute return focus, and tend to be exactly the type of manager not accessible to the general public. In order to get at these specialist managers, investors need to look for funds which are wrappers of really good fund managers. Even the best stockpickers can, and sometimes do, get it wrong and pick a howler of a stock. By combining two or three really good stockpickers you can feel the benefits of active management but not take on quite the same risk. An absolute return or multialpha approach offers exactly this. Quite often, multialpha approaches will actually already be blending the best of both qualitative and quantitative managers together for you. Really good treasure hunters make sure they search on land and sea for the best opportunities they can find.

International Investment - Stronger strategy

A multialpha approach often proves to be a good strategy in trying times, as the diversified approach covers managers with different sources of alpha, investment style, industry exposure and investment philosophy. Picking funds run by a seasoned team of fund managers and analysts with proven expertise in stock-picking through various market environments is vital. Good products, for example, should combine good stock-picking managers and allow them the ability to impact the portfolio equally. This gives the investor cover for different market environments and different sources of risk.

The more experienced fund managers would have seen more than one downturn and tend to have a nifty feel for what to hang onto, and how to hunt for something going up. So by all means, when picking a selection of active fund managers do “think local”. This will achieve both global diversification and utilise the expertise of local active managers who have full knowledge of their own corner of the investment world. They can navigate the murky waters of what to the layperson is unchartered territory. Find a manager with a specialist investment mandate, who really knows his onions, and then find another specialist who knows his sushi.

Trite as it may sound, there really is nothing as good as old-fashioned experience. There is a great phrase which sums it up nicely and it is that “experience never comes cheap”. And that’s just it. Only when you’ve suffered the nip of a falling market and felt it take a shark bite out of your returns, can you really appreciate the benefits of active management, superior stock picking and nifty diversification, despite the higher fees. True multi-asset investing, which takes into account specialist sectors such as hedge funds – good hedge funds – and even assets like property can provide positive absolute returns in tricky markets. The important point is also that you consolidate your gains once you have them and remember that choppy waters are not always a bad thing in the long run. As the old adage goes “could be good, could be bad” and it’s possible that those investing more at this time will be the ones who really reap the benefits in the future.

Lastly, let’s not forget the tale of one ship, the 138 year old tea clipper known as the “Cutty Sark” in London. While it was being restored last year, most of the ship - including the masts, deckhouses and saloon, along with half the planking - had been taken away for conservation. This turned out to be just as well, when one of the conservationists working on the rest of the ship left the vacuum cleaner on all weekend, which subsequently caught fire and nicely un-restored what was left of the ship. The irony is it took the fire crew a long time to douse the flames because the ship was in a dry dock. A bit of choppy water would have gone down a treat.