The five investing themes to follow this financial year

Next month marks the five-year anniversary of the sub-prime crisis in the United States, so it is timely to consider how the global financial crisis has affected portfolio construction and asset allocation decisions and why investors need to rethink traditional investment mantras such as long-term “buy and hold” strategies.

Portfolio construction must respond to powerful themes. The first is a slow, long grinding recovery in equity markets that takes years to play out.

As noted in this column in the July 5 to 11 issue of BRW, investors should look for a stronger sharemarket later in the year and possibly an equities rally in the New Year. But don’t expect a quick gallop towards previous peaks.

In a grinding recovery, more of the total sharemarket return will come from yield than capital growth.

Investors must ensure the equity component of portfolios has higher weighting towards high-quality blue-chip companies with more sustainable yield.

Investors should also increase the weighting of fixed interest, while being mindful of not using cash as a surrogate.

The move to bank term deposits and at-call savings accounts has worked but the opportunity cost of holding too much cash is growing as interest rates fall and yields on blue-chip shares and some fixed-interest securities rise.

The other key theme is diversification. Persistent high volatility in global financial markets is unlikely to ease soon.

The mantra of diversifying across and within asset classes is not enough; even diversified share portfolios were smashed during the GFC.

So here are five other themes that investors should consider when putting together a portfolio.

1. The rising correlation between big shares

Macquarie Equities Research has measured correlations between shares in the S&P/ASX 200 index and found the average pair-wise correlation is the highest in two decades.

Macquarie Research defines pair-wise correlation as the average correlation of each share’s return to the return on every other share, using one year of weekly returns. Simply put, this means blue-chip shares are moving up or down together.

A bad headline in Europe, for example, forces a “risk off” mentality and causes most stocks in the S&P/ASX 200 to fall.

Then the United States Federal Reserve hints at more quantitative easing and it’s “risk on” and stocks here rise as one.

If this trend persists, the case for using index funds, such as exchange-traded funds for exposure to shares in the S&P/ASX 200 will strengthen.

Why spend all that time trying to pick shares and take higher risk, when blue chips have greater tendency to move in the same direction?

That’s not to suggest investors should avoid holding blue-chip shares, especially those that pay higher yields, or stop investing in high-performing active-managed funds that invest in this market.

But for many, it makes more sense to use low-cost exchange-traded funds for blue-chip exposure and focus on securities selection in other markets.

2. Different diversification

A consequence of the higher correlation between big shares is the effect on diversification.

Portfolios need to include different investment styles, such as active and passive management.

So do not get hung up on the silly debate over the merits of using higher-cost active products that pick stocks, compared with using low-cost products that provide the market return.

Rather, it makes sense to use a mix of products, such as ETFs and active-managed funds, in order to include different investment styles in portfolios, thereby improving diversification and spreading risk.

3. The case for commodities

There is a good argument to include more direct exposure to commodities, again to improve diversification and reduce company and market risk.

Gold is an example: every portfolio investor should have a small exposure (no more than about 5 per cent), yet so many get exposure through gold shares that introduce company-specific risk and have underperformed gold in recent years as well.

A simpler approach is using exchange-traded commodities (ETCs) for low-cost commodities exposure. ETF Securities Australia recently launched 10 ETCs, covering agriculture, energy, industrial metals and diversified commodities.

ETF Securities argues that a small exposure to physical commodities can improve a portfolio’s risk-adjusted return over time. And the company is right about that.

4. Small bets, big wins

Under the above scenario, portfolios have a better mix of active and index exposures and more exposure to asset classes that have a weaker relationship with equities.

This improves diversification and reduces portfolio costs but it means lower returns.

The good news is that investors can focus on fewer active investments, such as shares or funds, because more of their portfolios are tucked away in index products, often using a “core and satellite” strategy under which index products form the core and active products make up the satellites.

Look for portfolio “alpha”, a return higher than the market, in shares that are outside the S&P/ASX 200.

Australia has some terrific small-cap fund managers; Standard & Poor’s Index Versus Active (SPIVA) report shows that more than 75 per cent of Australian small-cap funds beat the Small Ordinaries index over five years ending June 30, 2011.

There may be some “survivor bias” in those figures: Standard & Poor’s does not take account of the many small-cap funds that close because they cannot get traction in the market.

Nevertheless, investors should consider including small-cap funds with a consistent record of outperforming over several years. Taking a fund approach, which provides exposure to dozens of equities, improves diversification.

5. Every point counts

In a long, grinding market recovery, the best share investors can hope for on average is probably high single-digit returns, so each percentage point of fees must be scrutinised more than ever.

There is no room for managed funds that charge 1 to 2 percentage points in annual fees and consistently underperform, or paying high fees for full-service share brokers that provide patchy service.

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