[Column] Luigi Marinus: Benefits of diversification during market volatility

Recently volatility has increased in markets as sensitivity to news flow, particularly with regard to global inflation, has increased. As global growth appears to be slowing amid increasing energy prices and multi-decade-high inflation levels, the actions of Central Banks globally are being closely observed and analysed.

There is quite a bit of speculation around the direction of short-term interest rates and whether the current hiking cycle will lead to a recession. On the balance of probabilities, some forecasters may be reasonably accurate in their predictions, but the majority are unlikely to be correct. So, how does one navigate during these periods of uncertainty which in turn fuels volatility? The answer is simple: diversification. Diversification plays an integral role in portfolio construction to ensure that volatility is managed regardless of the prevailing market conditions.

Let’s unpack how to achieve diversification from an asset allocation perspective, as well as through effective manager selection and blending, using the PPS Conservative Fund of Funds as a proxy.

Optimal asset allocation to achieve diversification  

Asset allocation is the process of dividing an investment portfolio between different types of asset classes, such as stocks, bonds, and cash, as well as choosing the right mix of asset classes while constructing the portfolio with the intention to minimise investment risk and maximise growth potential or enhance returns.   
 
In the PPS Conservative Fund of Funds, we start with a long-term view of the strategic asset allocation (SAA) which aims to outline the asset allocation that achieves the inflation target over time without unnecessary risk. The balance required is to include enough growth assets to achieve the desired return but not too high an allocation to increase the risk of an unfavourable outcome.  
 
Over shorter periods, tactical asset allocation (TAA) is applied which makes marginal adjustments to the SAA to dial-up or dial-down risk as market conditions change. It is important to note that TAA decisions are made within predetermined target bands so as not to diverge too far from the SAA and ensure that diversification across asset classes is always maintained and within appropriate bands for the conservative nature of this Fund of Funds, which can invest across all listed asset classes and hold a combined maximum exposure of 40% to local and global equity.  

Choosing the right combination of asset managers

The second-way diversification is achieved in this Fund of Funds is through manager selection. As a multi-manager, we research asset managers both locally and abroad. This insight allows for comparisons of specialist managers (where only one asset class is invested in) and multi-asset managers (where investments are across different asset classes), noting which conditions are favourable to different managers and importantly from a diversification perspective, which managers deliver different risk-return profiles.  
 
The aim is then to combine managers with strong investment teams and stable business models that have proven above-average track records, but different investment styles into the Fund of Funds. The main advantage of combining complementary managers is that forecasting market conditions are not necessary. By introducing managers with different styles, the Fund of Funds should be competitive regardless of how markets conditions unfold. 
 
Proof is in the pudding 

The chart below shows how effective the Fund of Funds has been in achieving a competitive return while maintaining a lower-than-average standard deviation (which is widely accepted as the primary measure of volatility) since the inception of the retail class. The grey circles are all the funds in the ASISA category with a comparative track record. 
 
The PPS Conservative Fund of Funds has a lower standard deviation than the peer group average and is among the top quartile of returns over the nearly 10-year period. This highlights the benefit of the diversification strategies employed in the Fund of Funds as the market has experienced various cycles and shocks over this period, including the taper tantrum, COVID-19 shock, and subsequent pullback, Nenegate, Steinhoff and various inflation cycles. These events were near impossible to predict, but by maintaining exposure to managers with different styles, a competitive risk-return profile was maintained throughout.

Smoother risk-return profile

Due to the relatively low equity allowance, the Fund of Funds is aimed at the investor seeking a low volatility investment which still manages to achieve a long-term return in excess of CPI+2%. Since launching in 2007, the PPS Conservative Fund of Funds has built an enviable track record in a competitive ASISA category (SA Multi Asset Low Equity) by applying the appropriate amount of risk in asset allocation decisions and maintaining a diversified manager selection process. Even as volatility increases in markets, the process remains unchanged, and consistent monitoring will ensure that the risk-return signature is sustained for the Fund of Funds to remain competitive in the category.

Luigi Marinus is an Investment Analyst at PPS Investments

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