Financial markets last year were nothing short of unpredictable.
Few would have believed that the S&P 500 would close 2020 16.3 per cent ahead in a year when the global economy was on a knife edge.
While vaccine progress provides some hope for the future, there are still risks to their rollout and distribution. Advisers may be asking how they can protect their client portfolios from future setbacks as we learn to live with Covid.
‘Panic trading’ in response to the latest medical news has proved a poor strategy. When Covid-19 hit, the temptation was to rebalance based on an altered view of the world. However, markets were moving fast and took time to settle.
By trying to rebalance immediately, investors left themselves vulnerable to being out of the market at crucial moments and to some dramatic mis-pricing.
We consciously did not rebalance in our managed portfolio service at the height of market volatility, considering it too much of a risk. Instead, we waited until markets stabilised to appraise the new environment and make adjustments to investor portfolios.
That is not to say that advisers should not strive to build resilience into portfolios and to reflect the altered environment likely to emerge after Covid. Slumps will happen from time to time.
It is just that the next upheaval seldom looks like the last and there is a risk that investors are always looking in the rear-view mirror. In the wake of the global financial crisis, there was wholesale reform of the banking sector, yet investors lingered on this risk during the Covid crisis.
It is possible that they will do the same with the pandemic. Investors need to adapt their portfolios to cope with a range of scenarios because crises are inherently unpredictable.
Resilience
With that in mind, what does a resilient portfolio look like? Certainly, the answer to this or any other upheaval has not been to retreat into traditionally defensive assets.
While government bonds have performed well over the past year, yields are now so low that their protective characteristics are diminished. The same is true for cash. It may protect a portfolio in extreme conditions, but it is very expensive to hold and the opportunity cost may be significant.
The same is also true for ‘defensive’ equities. Blue chip stalwarts have, in many cases, not proved resilient in this crisis. Some have been on the wrong side of environmental, social and governance trade, while others have seen their business models come under threat.
The idea that investors can simply retreat into blue chips in the face of market turmoil has been blown out of the water. Any analysis of risk needs to be far more nuanced, considering a broad range of factors: interest rate exposure, commodity pricing, the risk-free rate as well as the unique circumstances of the economic environment.
There are some important long-term considerations that guide our thinking; the first is discipline. Volatility is always unsettling and it can be very difficult to stick to an investment process through turbulent times.
Collective experience is vitally important in keeping on a straight path. It helps to have been through previous crises, to have made mistakes and learned from them.
The right alternative assets can be a friend during any crisis. Many truly diversifying assets are held within investment trusts on liquidity grounds, so it helps to have expertise in this area. Equally, many alternative funds need to be treated as insurance policies.
These funds often will not keep pace with frothy markets, but will show their mettle during a crisis. It is often difficult to predict when they will be needed, so it is important to hold them through the cycle.
Balance
Balance is important. It has been a horrible time for value. Over the past few years, just as it seemed it could not get any cheaper, value and cyclical stocks lurched lower.
However, the response to the vaccine announcement shows how quickly it can bounce in the right environment. The key is not to have everything pointing in the same direction, but to focus on best of breed in all categories.
There is no fund manager that will outperform in all situations. This balance is also important for income, as UK income investors may have found to their cost last year.
There are reasons to believe we may be at an inflection point in markets. Many of the “winners” over the past year or more have benefited from record low interest rates and, crucially, low inflation.
However, as recovery gathers pace, and with the vast fiscal and monetary stimulus packages put in place by governments and central banks, this era of benign inflation may be drawing to a close.
As such, it is perhaps more important than ever to ensure that portfolios are not positioned for yesterday’s environment, but include some measure of inflation-proofing.
Alternative assets including commodities have proved protective in a climate of rising prices and should benefit from a weakening US dollar. Some of these cyclical assets have been unloved and therefore also score well from a valuation perspective.
Our view is that it takes time and experience to build a portfolio that is resilient in a crisis and manage the risks. Outsourcing can remove this burden from advisers and reduce stress during tough periods in financial markets. This frees advisers to focus on their clients.
Mickey Morrissey is head of distribution at Smith & Williamson Investment Management LLP
