Combining investment styles to withstand fluctuating market conditions

David Crosoer, Executive: Research and Investments at PPS Investments.

The past couple of weeks have been characterised by significant volatility in financial markets as investors have grappled with the implications of a pronounced slowdown in China and the possibility the US Federal Reserve may raise interest rates next week. In such times, having a portfolio diversified across complementary investment styles can stand investors in good stead over time.

Investors are often told to diversify their risk across asset classes, sectors, geographies and currencies. However, a factor that is rarely mentioned – at least in the retail market – is diversifying portfolios to include complementary investment styles. When market fundamentals change significantly, style diversification can be particularly important.

An investor for instance that is only exposed to one particular investment style may have to live with severe underperformance during certain periods when it is out of favour. For the past five years, for example, investors with a significant value bias in their manager selection process would have experienced significant relative underperformance compared to more momentum-driven strategies, Of course, provided the investor can stick with this manager, the investor could also ride the wave of outperformance when the manager’s approach is rewarded.

Unfortunately investors find it difficult to stick with a manager whose style happens to be out of favour, and that investors can often try to chase performance. This can often need to poor performance as investors keep switching between funds.

It is equally difficult knowing which manager will do well beforehand. A manager that outperformed because of a large position a particular share in the past, might not repeat its outperformance should that same share underperform. Past performance is no guarantee of future performance, and on occasion it can be a very poor predictor. This is especially the case when market conditions change.

The current environment is particularly challenging as the market is unsure both about global growth and potential US interest rate hikes, and this is resulting in significant volatility across investment styles.

A multi-managed approach aims at delivering more consistent performance over time by combining more than one manager, and consequently exposing investors to more than one approach. By its very nature, the multi-managed fund should be more consistent than the manager that follows just one style.

Combining managers with different styles can thus help to reduce the exposure of portfolios to any one particular view. Different asset managers could have very different views or positions on the same share. A case in point is Naspers.

Managers will have different exposure to Naspers depending on their style. A manager whose approach is to track the index could have as much as 12% in this particular share, since Naspers makes up 12% of the SWIX benchmark. A more value-focused manager that does not hold Naspers at might underperform the benchmark in the short-term given she perceives it to be expensive. And a manager that is optimistic about the future earnings potential of Naspers might be even overweight it if she is focused on benchmark-relative performance.

These different investment styles perform differently during various market cycles. The value focused style for example could underperform when the market gets increasingly expensive (like in the past couple of years), but should hold up better when valuations become more important (which is often the reason for a correction).

The approach of combing managers with different styles requires us to have a very deep understanding of each manager’s strategy, because it is very important that the manager sticks to its style. It would be highly problematic for instance if a value manager included in a portfolio suddenly decided to buy an expensive growth share to keep pace with its benchmark in a period that it was underperforming, as this would exposure the portfolio to too much momentum style risk.

Importantly, multi-managers do not try to pick the top-performing manager, but rather to combine managers with sensible strategies who are having an edge in terms of generating outperformance. They look for as many sources of returns as possible, while acknowledging that the future is uncertain and is likely to surprise.

Saving for one’s retirement or other important financial goals can be an arduous endeavour that requires discipline and commitment. We believe that a multi-managed approach can helps investors to achieve their goals by giving them a more consistent return profile over time.