A question all investors, and CIOs, need to be asking themselves much more is how can I get greater diversification into my portfolio?
Right now, if markets had a personality it would be momentum. It has comfortably outpaced both value and quality investment styles over the past 12 months, with the gap now stretching to about 45% versus quality.
This has led index-tracking funds to perform strongly year-to-date as they tend to do well in more concentrated and momentum-driven markets. Now, if you believe in diversification, you should be holding less of the things that are more concentrated. This can be a real challenge for investors.
The thing to remember however is that every equity style will have periods where it appears superior, just as every style will go through stretches where it seems more fundamentally challenged. Just speak to a value manager over much of the past decade as evidence of the latter. Yet market history repeatedly shows us that no style remains in (or out) of favour indefinitely.
The problem is that investors almost always want to own more of a style after it has worked well. In this case it’s the classic of momentum chasing momentum. The problem is that if you chase something hard enough, you can easily fall.
One way to prevent tripping yourself over is to avoid the classic mistake of crystalising losses by selling those managers who are underperforming simply due to the divergence in investment styles.
While those who favour momentum as an investment approach may currently appear as winners, as quality and value approaches struggle, it doesn’t mean this trend will continue. Markets move in cycles, and quality stocks are often more popular during times of economic uncertainty. This is because people want to invest in safe, reliable companies that may be less newsworthy but can offer more stability.
When it comes to diversification, the benefits of diversifying across asset classes are generally well understood. But can you also achieve this diversification across investment styles? There are several key investment styles to be aware of. To name just a few: you have value, quality, low volatility and, arguably, size. You might notice I have not included growth as a separate style factor, and this is because growth and value effectively represent contrasting approaches – with growth focusing on future earnings potential and value focusing on exploiting mispricing.
Quality approach
Given the dispersion between momentum and other styles has been so extreme, at St. James’s Place we have started to lean, albeit very slightly, back towards quality in our approach.
For context, some six years ago approximately 54% of our equity exposure was allocated to quality orientated styles. Today that allocation is around 32%. Our global equity allocation at SJP is always valuation conscious and, given the compelling opportunity at present, quality is an area where we are considering increasing our allocation once again.
If you invest in funds, there are two key ways to achieve diversification across styles. The first is to select active managers with distinct style biases, the second is to gain exposure through indices that capture these style factors.
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Investing exclusively in market-cap weighted index funds does mean you are implicitly accepting a momentum bias, however. As companies outperform, their weight in the index increases, resulting in higher allocations to recent winners. There is nothing necessarily wrong with this, but it is important to recognise the risks you are taking on.
There is a reason I didn’t include momentum in my earlier list of styles. Unlike other styles which can be grounded in fundamentals, momentum is largely driven by trends and sentiment, making it more challenging to assess and trade fund managers on momentum alone.
Similarly, there is also further ambiguity with quality as an investment style, in that it is quite difficult to define. However, a reasonable expectation through time is that quality as a style should deliver lower volatility than the broader market, generate a growing stream of cashflows that protect real purchasing power, offer the lowest probability of capital impairment and provide a defensive profile during extreme market stress.
Further afield
A natural follow-on question from the discussion on equity diversification is how you can also achieve this within fixed income. One way is to think about your split between inflation-linked and non-inflation linked bonds. At a time of uncertainty around inflation dynamics, we think a sensible starting point should be a 50/50 split between the two.
Another area to consider is emerging market local currency debt which is a market that evolves considerably over time and tends to be a great diversifier relative to equities and bonds, given a large portion of the returns and risk is driven by emerging market currency rather than interest rate movements in those markets.
We know that different styles move in and out of favour over time – that is not new. What matters is the extent to which the divergence is now shaping overall outcomes. A relatively small group of companies are driving a disproportionate share of returns, often supported by strong sentiment and increasingly crowded capital flows.
Of course, the sensible medium-term approach is not to ignore momentum – but nor to chase it blindly. The discipline is in recognising what has worked, asking what is already reflected in the price and being clear-eyed about where risks are building.
That means focusing on valuation – buying more attractively priced assets, maintaining diversification discipline and being selective in what we hold.
Justin Onuekwusi is chief investment officer at St. James’s Place
