Three strikes and you are out?

South African investors who have benefited from the glorious bull market since 2003 have had two wake-up calls over the past year. In May last year and last month local equity and bond markets fell sharply as investors demanded a greater expected return

Does this renewed focus on risk have any implications for how investors should construct their portfolios, asks David Crosoer of Glacier by Sanlam?

Investors have largely got away with ignoring risk over the past four years.  Or - to put it a bit differently - past performance has been a relatively good predicator of future performance as the funds that have taken on greater risk have continued to be rewarded.  The danger with constructing portfolios on this basis is that past performance is not always a good predicator of future performance, and it is a particularly poor predictor when the market no longer rewards investors for taking on risk.

Investors who have ignored risk got hit hard in May last year and last month.  The JPMorgan Emerging Market Bond Spread illustrates the premium investors demand for holding emerging market debt (which is more risky) over US Treasuries.  When investors are not concerned about risk this spread tends to be tight.  

In addition, the local funds that had performed best in the four year bull market tended to be the ones that fell the most in the market corrections.  This was because funds that took on the most risk (by holding riskier assets or shares) tended to fall the most. 

Risk-adjusted measures focus not on the absolute performance of the fund, but against the amount of risk needed to achieve that return.  There are a number of risk-adjusted measures investors can look at.  Two of the most popular are the Sharpe ratio and the Sortino ratio.  These measures tell us how much risk a manager has taken on to generate his return.  Both measures provide a more detailed analysis of the funds performance, than simply focusing on the absolute returns. 

The implication appears clear.  A substantial re-pricing of risk will adversely affect South African equity markets and other emerging markets.  And funds that have chased performance (by holding more risky assets or shares) will be most adversely affected by a re-rating of risk.  Going forward, investors need to ensure that their portfolios are diversified across both local and international markets, and that their local selections take risk-adjusted performance rather than past performance into account.  The JP Morgan Emerging Market Bond Spread is still at historically low levels, despite the recent market correction.  It is not too late for investors to construct their portfolios appropriately.