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De-Risking in Switzerland: be first to diversify your portfolio

There are many parallels between the 1920s and the 2020s. Both took off with a roar: stock markets across the globe reached peak valuation (both in terms of the nominal indices as well as P/E ratios) and unemployment hit record lows.   Companies then as now also enjoyed access to more capital at a lower rate than previous generations could’ve dreamed of. 

But today, just as in the 1920s, investors’ long-held optimism has abruptly evaporated. After a bull rally in February that saw the S&P500 reach the highest ever level, it then fell off a cliff thanks to panic selling over the global impact of the coronavirus pandemic. 

This year’s stock market crash was the biggest since the Great Recession and with most of the developed world placed under lockdown, the global economy has entered a downturn deeper than any other in living memory.

These events have placed portfolio risk management squarely at the centre of conversation across financial capitals. And with the word diversification now on the tip of the tongues of investment managers across the globe, early birds are jostling to ingest a magical tonic before gatecrashers try to enter the party.

What happens to a portfolio during a crisis?

A market correction is defined as a fall in nominal value of greater or equal to 10%. Classic advocates of portfolio diversification use the “not putting eggs in one basket” analogy to illustrate the importance of owning multiple stocks. The theory goes that if you own one stock and its value drops by 10% then your entire portfolio has just lost 10%. whereas if you own 2 stocks and one drops by 10% whilst the other only decreases 5%, then you are 2.5% better off than the mono-stock scenario. 

In fact, the number of stocks in a portfolio, as well as their risk-return profile, has been mathematically modeled (Figure 1) and we can garner some useful insights:

  • Portfolio volatility and return move in tandem -> the higher the return, the greater the volatility (i.e. risk)
  • The number of stocks in a portfolio directly impacts the risk-return profile
  • Once a threshold in stock number has been reached, increased diversification offers diminishing risk and return potentials

The phenomenon above can be observed across most portfolios. If you are holding an asset with variable value (i.e. bond, stocks, ETFs, REITs, properties), then you will experience this.

Figure 1. The impact of portfolio population on return and volatility

Source: JVB

Do you know the typical diversification mistakes?

Many modern investors deploy the diversification strategy without fully understanding its implication or the right way to implement it.

Issue 1:  Putting the eggs in multiple baskets, but all the baskets into a single car

The rational response to “don’t put all your eggs in one basket” would be to place your eggs in different baskets. Yet nobody seems to question where the baskets themselves are being placed. If these baskets are put into the boot of a single car and that car was involved in a crash, then being placed in different baskets would do the poor little eggs no good, since the baskets themselves would have been smashed. 

Equally, investors would do well by questioning the underlying risk factors facing each asset they own, to ensure all risks are mitigated as much as possible by holding assets that share completely different risk profiles. 

For example, if investing in financial stocks is your thing, it is no good to go out and own 10 different banking stocks, simply because if there is a systematic issue with the industry (like the 2007 Subprime Mortgage Crisis) then the entire industry would be impacted. Instead, it is far better to own some gold alongside your favourite banks, given that these two assets are uncorrelated (i.e. the movement of one has little effect on the movement of another). In fact, it has been documented that assets within similar classes share a 60% correlation (meaning that their nominal performance is 60% identical). 

Consequently, the perception of diversification through owning multiple stocks often completely masks the underlying risk that remains within a portfolio. This can make investors complacent and the portfolio vulnerable to adverse market conditions.

“Don’t put all your eggs in one basket” is great,

but if you have multiple baskets,

where do you place those baskets themselves?

Issue 2:  If one always goes up when the other goes down, you get … zero

The second issue with incorrect diversification is the adverse impact on the expected return. As Figure 1 has clearly demonstrated, increasing the stock population drastically reduces portfolio volatility but also trims the expected return simultaneously. This isn’t entirely surprising because investors often perceive diversification as packing in a series of negatively correlated assets (i.e. their pricings move in different directions under the same circumstances). Imagine if your portfolio had 2 companies: one making umbrellas and the other making sunglasses. On a rainy day, the umbrella stock rises whilst the sunglass stock falls and the opposite happens on a sunny day. Over the course of the year (and assuming no cloudy days!), your portfolio will see little increase because no matter the weather, the rise of one will ensure the fall of the other, given the two are negatively correlated.

How to diversify right, the Ray Dalio way

As you can see, most modern investors practice a form of diversification that does not address the key objective of diversification, which in essence is reducing portfolio risk without impacting performance. 

They merely undergo risk sharing (owning multiple stocks with similar risk features) or risk substitution (owning negatively correlated assets). 

Instead, your portfolio should be composed of a dozen entirely uncorrelated and profitable assets. This should largely eliminate any long-term capital loss risk from your portfolio without impacting on its underlying performance. It is what is known as Ray Dalio’s Holy Grail.

The table below compares the features of a typical portfolio versus that of a properly diversified one.

Features Typical portfolio Diversified portfolio
Asset mix Mostly publicly traded financial assets (e.g. bonds and stocks) A broad range that incorporates both listed and unlisted assets
Valuation Tends to be medium to high, usually contains growth stocks Usually low
Interest-rate dependence Yes (if invested in public bonds) No
Portfolio yield Low single-digit High single to low double-digits
Correlation with the global market High Low
Liquidity Usually high Medium to high

 

How do you diversify your pension fund (i.e. your pension)?

Take a typical pension plan as an example, which is usually composed of stock and bond index funds in a 60-40 mix. By adding in a local Swiss property component (centrally located, residential, can be used for both long-term local letting as well as short-term holiday accommodation), the volatility of the portfolio can be significantly reduced (property, in general, is more stable than financial assets) and the yield substantially enhanced.

The outcome of a properly diversified “holy grail” portfolio produces a superior return at a given risk level. In layman’s language, this means it returns more than the market is up and falls less when it’s down, as demonstrated in Figure 2.

Figure 2. A properly diversified portfolio can deliver superior return whilst minimising risk (S&P500 = 100% invested in a US S&P 500 stock index fund; Mod Risk = a moderate risk portfolio of 40% US stocks, 30% international stocks and 30% high-quality bonds; Thun Mod Risk = fully diversified across 14 different asset classes comprised of stocks, bonds, real estate, and commodities)

Source: Thun Financials

Diversification options available to Swiss investors

We take a base-case scenario of a pension portfolio comprised of stocks and bonds in a classic 60-40 mix and scanned the market for alternatives. Our criteria are based on a series of uncorrelated characteristics to the base-case, namely:

  • Different asset class
  • Fairly valued
  • Independent of interest rates
  • Profitable and high-yield
  • Low correlation with the global market
  • Acceptable liquidity

With these criteria in mind, we have identified a list of candidates below.

Features Le Bijou Bonds Le Bijou Investor’s Club CS Real Estate Fund LivingPlus iShares Physical Gold ETC (SGLN) iShares MSCI Emerging Markets ETF (EEM)
Overview Provide loan capital to Le Bijou which leases out prime city apartments in CH and refurbishes them to a high standard before letting to guests on a short-term basis. Provide equity capital to Le Bijou for its capital and operating expenditures. A fund dedicated to investing in residential healthcare living properties to seniors in CH. An ETF that invests directly in physical gold and offers investors virtual physical exposure to the precious element. An ETF that provides investors direct exposure to emerging markets where most of the future growth is originated. 60% of the portfolio is located in Asia.
How does it make money? Providing a fixed rate of return to investors Return profit to investors after deducting operating expenses Through an increase in valuation of the underlying real estate asset Through appreciation in the spot price of gold Through appreciation in the underlying stocks
Yield 5-7% 4-5% Not applicable Not applicable 2.9%
Capital appreciation Non-volatile Non-volatile 8-10% 7-10% 8-10%
P/E 7-10x 7-10x N/A, although the average SIX PE ratio is around 35 Not applicable 14x
Max drawdown Non-volatile Non-volatile -35% -60% -55%
Global RE market correlation None None to negative Medium to high None Low
Global financial market correlation None None Low to medium Low High
Liquidity Investors can sell through the internal marketplace Investors can sell through the internal marketplace High as it is publicly traded High as it is publicly traded High as it is publicly traded
Suitability Good play for investors seeking CH real estate exposure whilst demanding a fixed income. Good play for investors seeking CH real estate exposure whilst wanting to combine a profitable dividend-paying business with high capital appreciation potential Good for investors seeking instant exposure to the CH real estate market with a senior care flavour and needing high liquidity. Good play for investors seeking the haven of precious metal, which is a great hedge during times of extreme uncertainty. Good play for more adventurous investors seeking to invest in the BRICS economies. However, this remains heavily intertwined with the global financial market.

 

Looking forward

The key to diversification is reducing risk without impairing the performance of underlying assets. Most investors appreciate the risk reduction part yet fail to properly grasp how asset correlation works. This results in asset mixing rather than proper diversification. 

Given that most assets in the same class share a high degree of correlation, this is a poor way of de-risking a portfolio. The key is, therefore, to pool high-quality, uncorrelated assets together and leave them to grow for the long-term. This strategy will serve investors’ financial future well.

But seasoned investors know that finding a profitable and private asset that delivers a sustainable long-term return is a little bit like hunting for a Vanguard-class submarine in the ocean. So investors would do well to remember to hunt under the radar, for those rare hidden gems that are often overlooked by the market. Then investors have a chance of finding the Holy Grail:  assets which are very fairly valued but which are also tuned for impressive performance.

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Thank you

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