Investors urged to consider diversification strategies following market rally

With market jitters growing over the sustainability of the local and global equity market rally that has taken place over the last few months, equity investors concerned about downside risk have been urged to diversify their portfolios to protect themselves in the event of a market correction.

According to Eben Karsten, portfolio manager at Blue Ink Investments, diversification remains key to a successful portfolio. “It is difficult to know when a bull market will turn bearish, which is why it is so important to always maintain a diversified exposure to various investment strategies. This could include alternative strategies such as hedge funds and other asset classes that offer a degree of protection in periods of market turbulence.”

Karsten says the rally in the local equity markets over the 3^rd quarter of 2010 resulted in excellent returns for investors compared to other asset classes. During the period, the All Share index (ALSI) returned 13.3%, compared to the 8% of the All Bond Index (ALBI) and 3.5% recorded by the Blue Ink All South African Hedge Fund Composite (BIC), which tracks the performance of around 100 hedge funds in South Africa.

However, Karsten says that with volatility levels of the ALSI for the 3^rd quarter measured at 24% compared to the 1.2% of the Blue Ink Composite, it is clear that equity investors are taking on a lot of risk for their returns.

*Annualised Volatility in brackets

“Valuations remain varied across sectors; the estimated current Price/Earnings (P/E) on the local market is around 12, not much below its historic average P/E of around 13. While the market may not be expensive, a clear case for markets being cheap can’t be made either. At best one could say that the market may beclose to fair value.

He says there still exists a number of varied risks that could cause equity market returns to be far less than what market participants expect. “In the current environment, investors would need to ask themselves whether the risk associated with a high weighting towards equities is justified.

“Instead, there is a strong argument for persisting with the more conservative asset classes as they offer positive real returns with very little risk. The strong returns delivered by local hedge funds during the global economic crisis emphasized the value of risk protection strategies during uncertain times.”

The Blue Ink Composite shows that the three-year total return from the JSE ALSI came to 7% with volatility of 22.4%. In comparison, the average hedge fund returned 29.7% with 3.6% volatility over the same period.

“Due to the lower risk levels taken by the average hedge fund in South Africa compared to equity funds, if we get a pull-back in the markets, hedge funds will again outperform equities.”