Once again stockmarkets are dominating the headlines, as concerns about the economic impact of the Covid-19 strain of the coronavirus draw the focus of investors from the long-term horizon to the here and now. In these situations, many investors naturally extrapolate recent falls into the future and become overly risk-averse. In order to help investors through this period, we must both address these concerns and change the narrative.
While Covid-19 is naturally causing concern and may be devastating for those who contract it, from a purely investment perspective, the environment is improving rapidly for most investors and so we are excited about the opportunities ahead.
The starting point is important, however. In order to take advantage of the lower asset prices offered by the equity markets, it is essential the portfolio was not over-exposed to risk assets before their prices started to fall. Periodic drawdowns are simply part of the market cycle and should not come as a surprise to professional investors.
Multiple scenarios
Rather than optimising portfolios for one possible scenario, sensible investment managers consider a range of potential paths and balance their portfolio accordingly. To use Morningstar as an example, we have been warning about the risks posed by inflated asset prices for the last couple of years and hence our portfolios were somewhat defensively positioned by limiting exposure to the most expensive asset classes. We did not remove all risk from portfolios, however, as we were acutely aware that expensive assets can continue to defy gravity for extended periods of time.
Providing your investment managers have considered a range of possible outcomes, you should expect the returns of your clients’ portfolios to remain within your and your clients’ expectations. In contrast, beware of investment managers who are seeking to ‘de-risk’ portfolios at this stage, as it suggests they were carrying too much risk going into this situation and are now not able to capitalise on the opportunities presented by lower prices.
Portfolio exposure
As long as portfolios remain within expectations and risk guidelines, the next priority is to maintain the exposure of the portfolio through this volatile period. Sharp moves in the price of investments change the balance of the portfolio – for example, if 50% of a portfolio falls by 10% and the other 50% rises by 10%, the portfolio will have 5% more in the rising asset than before the price move.
Left unchecked, this results in the investor owning increasing amounts of the asset that is becoming more expensive and less of the one that is becoming cheaper. It is therefore essential that investment managers have a robust and responsive ‘drift’ policy. If you don’t know what the policy of your portfolio manager is, now would be an excellent opportunity to find out.
Improving returns
Having ensured the position of the portfolio remains in line with objectives, the next step is to look for opportunities to improve the expected returns of the portfolio by finding underpriced assets. This requires in-depth fundamental research rather than knee-jerk reactions.
A longer-term perspective enables investors to compare the current price to a realistic appraisal of an asset’s fair value and use this comparison to identify assets that have become either unusually cheap or expensive. This in turn, enables investors to improve the overall expected return by increasing exposure to the former and reducing it to the latter.
This ability to look ‘over the horizon’ and act in a long-term way is unusual in the current environment and conveys a competitive advantage over those that lack the resources, discipline or infrastructure to conduct the necessary research while prices are volatile.
As we take this longer-term perspective, it is important to separate permanent damage that will impact the long-term fair value of an asset from temporary damage that will quickly be forgotten.
While numerous epidemic outbreaks in the past have led to short-term losses in global equity markets, these losses have tended to be recovered relatively quickly, suggesting that sentiment and, ultimately, fear have been the main driver rather than a longer-term economic impact.
Buying opportunities
If the impact is short-term, price declines may produce buying opportunities. Warren Buffett, chairman and CEO of Berkshire Hathaway, recently observed: “You don’t buy or sell a business based on today’s headlines. If the market gives you a chance to buy something you like and you can buy it even cheaper, then it’s your good luck.”
Through this lens, some asset classes already appear attractive to us – most notably energy stocks and UK equities – however, others continue to remain unattractive despite the recent falls. Still others have become eye-wateringly expensive. It is therefore important to be selective when changing portfolios while remembering that valuation tends to be a poor predictor of near-term returns.
At present there does not appear to be sufficient diversification in the returns within asset classes to indicate that we should change our asset selection significantly – however, we would expect further valuation anomalies to occur as the current period of volatility progresses. It is essential that investors are prepared to capture these opportunities as they arise.
Make no mistake – the human toll paid to Covid-19 has already been unacceptably high. As investors, however, our minds remain on what we believe is most important when investing – namely, balancing risk and reward and coaching ourselves and others to make good decisions.
Dan Kemp is chief investment officer, EMEA at Morningstar Investment Management Europe
