Been to the cinema recently?
If you have, you may have seen the recent blockbuster Oppenheimer, in which director Christopher Nolan tells the story of how Robert J. Oppenheimer gradually comes to appreciate the enormity of his creation, and the profound impact it will have on the world.
I believe that investors in today’s markets need to travel down a similar (but thankfully less destructive) path of realisation.
The good news is that this realisation, unlike Oppenheimer’s, could help investors avoid significant damage to their portfolios.
The bad news is that the adjustments required are likely to be an uncomfortable step outside of the well-trodden, comfort zones investors have been used to investing in recently.
Context
Over the last decade, markets have been dominated by a few strong trends.
These trends have been very positive for shares in high growth sectors (such as technology), mega cap companies and the US market more broadly.
Because most indices are market-cap weighted, periods of strong trending like this increase concentration: winners keep winning so indices and portfolios become more concentrated in those winners.
This is where things may get uncomfortable.The effect of this is particularly pronounced when the trending is strong in the larger companies, as it has been.
This, too, shall pass.
Any long-term study of markets will show that markets tend to move in long-term cycles, and through different regimes. The strong trending in place recently has left many portfolios exposed to significant risk of loss if there is a shift in the market regime. The return of inflation is a potential trigger.
To try and get a sense of how unbalanced portfolios may be, we looked at the largest UK based funds in the Investments Association’s 40-85 per cent equity fund sector.
Avoiding losses is a key part of success in investing.This is a large and widely used category of funds that includes the classic 60/40 benchmark. I took the largest passive fund as a proxy for the benchmark, alongside the four largest active funds:
As of August 31 2023, these funds held more than £28bn of UK savers’ money so this accounts for a large chunk of UK portfolios.
Using Morningstar’s data, we then looked at the correlations between these largest funds over the last 10 years, in other words how closely the largest funds move in line with each other. A correlation of one, or 100 per cent, means that two funds or investments move in lockstep.
Each of the five largest funds has a correlation with the other members of the group ranging from 0.82-0.95.
On average the correlations are a lofty 89 per cent, and this picture does not improve if you include the next five largest funds either.
How has this happened?
When markets trend strongly for a number of years, portfolios can end up converging. Underperforming contrarian managers lose clients, while more flexible managers adapt to the market environment.
Why does this matter?
The trouble comes when trends end and market regimes change. No amount of diversification will help if everything you own is highly correlated. An investor holding a portfolio of the above funds might see their statement and assume they had diversified prudently.
In practice, however, this level of correlation means they have not achieved proper diversification.
2022 provided a preview of what those losses could look like: in 2022 the average balanced fund fell 13 per cent, and after a bit of a recovery this year, it is still down 6 per cent.
The largest active fund in the category, with its distinctive growth style, fell as much as 31 per cent, and today is still down 22 per cent.
What can investors do?
Advisers need to ensure that your clients' portfolios are properly diversified. That way, if one portion of the portfolio crashes, the other portion can help cushion the blow. The practical steps anyone can take are:
Look at the correlations, particularly of the largest holdings in your portfolio. This data is readily available from data providers, often for free.
Start by replacing the most highly correlated elements of the portfolio to lower the average correlation as efficiently as possible.
Look to add exposure in areas of the market that are under-represented now. This is where things may get uncomfortable.
For example, value-oriented funds have a great long-term history but have struggled in the post GFC area. These are generally under-represented in portfolios at the moment.
Conclusion
The past 10 years have generally been great for equity investors as global markets have been strong. Success can breed complacency though and high intra-portfolio correlations among the biggest funds are a warning sign that portfolios may lack true diversification.
As Oppenheimer memorably says of his creation: “They won’t fear it until they understand it”. Avoiding losses is a key part of success in investing and so checking your portfolio correlations should be a priority before it is too late.
In practice, investors have a choice today; they can either adjust their portfolios, or their expectations. Those who choose to adjust their return expectations must face the harsh reality that they will almost certainly have to lower them.
Dan Brocklebank is director, UK, for Orbis Investments
