Call to diversify investments to avoid GFC style losses post COVID-19

The COVID-19 pandemic has again exposed the fundamental flaw of balanced funds – expected “defensiveness” of traditional diversification approaches fail to perform in sharp market downturns.

Investment manager Cor Capital’s Tom Rachcoff says: “It happened during the Global Financial Crisis (GFC) and now we have had a repeat performance with the COVID-19 generated market turmoil in the first quarter of 2020.

“Many investors, and this includes popular retail and industry superannuation funds, would have been shocked by just how much risk they held in their balanced funds, some experiencing drawdowns of between 15% and 20% in the first quarter. For many, the negative impact on their portfolios would have exceeded their risk appetite.

“It’s not difficult to understand why. Over the years, these portfolios have switched from low interest-bearing government bonds to infrastructure, credit and property in the belief these assets would act as defensive proxies for low yielding debt instruments.

“But when the market downturn hit in late February, these assets were far more closely correlated to growth assets than they believed. Airports, commercial property, and corporate credit are linked to GDP expectations as the global shutdown has graphically exposed.

“It means many traditional ‘balanced funds’ held between 60% and 80% exposure to growth assets, when their belief would have been that their exposure was much lower. It’s little wonder they were shocked in March at their portfolios’ growth risk exposures.”

Rachcoff says that most investors must accept that their portfolios do have risky exposures to assets that they once considered defensive, and that unless they address their asset allocation, they will continue to experience portfolio falls in times of economic weakness – falls that will be compounded when there is a systemic risk event such as COVID-19.

“At this junction, this is particularly concerning given the bleak global economic outlook and the fact that a sustained and deep recession is a real possibility. Portfolios tilting toward high levels of growth asset risk may be flying blind into a serious headwind.”

He says investors, whether institutional, wholesale or retail, must accept the fact they have no idea what markets will do, and, in fact, the only thing they can be certain of is that there will be surprises.

“A weakness of traditional asset allocation approaches is the reliance upon asset class return forecasting and varying correlations in the build of a relatively poor risk management framework.  The framework breakdowns in periods of surprise, notably within systemic events.  These breakdowns are particularly damaging to those in or near retirement, and avoided by those investors that seek more absolute returns with a focus upon protecting wealth.

“For these investors, it is more important to build ‘all-weather’ portfolios that are purposely designed to protect wealth so that they perform like a balanced fund in a rising market but like cash and gold in a falling market.

“The premise of such a strategy is built on the belief that it is extremely difficult to forecast asset class returns; and that the most robust portfolio possible will be diversified based upon fundamental economic drivers for all environments. It is the antithesis of what is usually considered ‘diversification’, especially in the superannuation industry.

“You see a lot of portfolios that are supposed to be ‘diversified,’ but they’re really 70 per cent growth – like ‘balanced’ super funds. Even if they’re rebalancing, they’re just rebalancing from growth to growth. Every time we have a major systemic event – it happened in the GFC, and it has happened again – we see the correlations of the assets in a balanced fund go to one, and there’s no defence for that,” he says.

“Investors should consider a more fundamentally-diversified managed fund not over-reliant upon growth risk, which can be used as an alternative asset within a broader strategic asset allocation or as a standalone medium-term absolute return investment,” says Rachcoff.

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