Know what you own

Know what you own

The proliferation of investment products and financial literature has been a boon for investors – and it has not. Never before have investors had more information about a wider array of investment options and about the state of the market. And yet, for all this, the age-old challenges of investing remain unresolved.

Markets still rise and fall, and from time to time, these runs can go on for sustained periods. In these periods, markets can behave erratically, and oftentimes investors are their own worst enemy, influenced by fear, greed, myopia and hubris.

To invest – and to stay invested – at times of market turbulence takes two things: a firm belief that the investment strategy you have chosen, and the principles on which is it founded, offer solid ground to withstand the shifting sands of market sentiment; and the wisdom to stick to this strategy. In the words of iconic investor Peter Lynch, “know what you own, and know why you own it.”

The case for passive

Take index-tracking funds as an example. Index tracking funds are mutual funds or exchange-traded funds (ETFs) that invest in a select set of companies according to a predetermined set of rules. These are considered “passive” investments, as asset managers are not required to actively select which companies to invest in, but rather follow a particular rules-based formula.

Although a forty-year old invention, the growth, proliferation and popularity of these products is a recent phenomenon. The effects they might have on the market are only now being explored, and how such products will fare during a sustained market downturn remains untested. (Click here to read more on ETFs and capital markets.)

Certainly, there is a place for passive products in every investor’s portfolio. And passive products have done much to democratise investing through lowering fees and barriers to entry for individual investors. But the point remains that index-tracking funds are not the fail-safe solution to the age-old problems of investing. Ultimately, investors still need to know what they’re invested in, and what the risks and drivers are of any investment. Arguably, this is a far more challenging and nuanced problem than many investors realise.

“Knowing what you own is hard. Not knowing what you own is dangerous.” - Litowitz and Portnoy, Magnetar Capital

In their paper, “The art and science of knowing what you own”, Liwotiz and Portnoy use the example of a typical “balanced” portfolio, arguing that this offers the illusion of diversification rather than the real deal. Citing the example of stocks and bonds, Litowitz and Portnoy show that 10-year U.S. Treasury Bond and the S&P 500 Index have been “positively, though variably, correlated” from 1960 to the late 2000s. They then reason that while a typical balanced portfolio may hold investments across asset classes and industries and countries, the underlying factors that drive these assets are not sufficiently diverse.

This is a pervasive and persistent anomaly. A case in point for local investors is commodity-based emerging market equity, which is highly correlated with South African equity. Thus, whilst it may seem that adding Russian or Brazilian equity to a South African equity portfolio would bring new markets and names, the reality is that these commodity-driven countries’ equity markets would achieve little by way of portfolio diversification.

Given the inherent unpredictability that characterises capital markets, at Cannon Asset Managers we build portfolios by first examining the intrinsic value of asset classes, their return attributes and – in the case of multi-asset portfolios – their correlations, covariance and other diversification attributes.

This approach has produced effective single- and multi-asset portfolios that have achieved solid results in domestic and global portfolios over the last two decades. Tactical asset allocation is used to adapt to shorter-term market conditions and inefficient asset pricing, mitigating risk and enhancing portfolios returns.

Our investment solutions build on these insights and the evidence to construct portfolios that range from low-cost, asset-class matching, multi-asset passive solutions through to high concentration, high conviction active solutions.

We operate across the investment spectrum to take advantage of the low costs associated with matching the market in passive solutions at one end of the spectrum, while simultaneously seizing upon the rich opportunity that resides at the other end of the spectrum in the form of highly active portfolios. We tend to shy away from “the middle”, where industry solutions often produce below-market results at above-average costs. This is where the “faux-diversification” and “passive-pretending-to-be-active” funds are to be found.

Case in point – the Global Growth portfolio

Asset Class Exposure
Source: Cannon Asset Managers, 2019

Cannon Asset Managers’ Global Growth portfolio helps to illustrate the point. Of our low-cost index-tracking funds, this portfolio offers amongst the highest compounding potential, with the added benefit of hard currency returns. This multi-asset, multi-geography and multi-currency investment is truly diversified in a number of ways:

  • The emerging market equity weight is high at 30.7%, given that China, India, Indonesia, Mexico, the Philippines and others is where income growth, new markets and industrial dynamism are likely to come from over the next 20 years.

  • The 5% thematic weighting offers exposure to emerging industries such as biotech, artificial intelligence, robotics and other rapidly developing fourth industrial revolution trends. Together with emerging equity, this offers strong growth potential, but also comes with the potential for heightened portfolio volatility.

  • The 43.7% developed equity component provides steadier equity returns from mature markets, acting as a counterweight to the aforementioned volatility. Risk sentiment between emerging and developed markets is correlated differently, which means the asset classes can be blended to provide the proverbial “free lunch”.

  • The almost 10% holding in precious metal is unusual in a long-term portfolio, given that gold cannot compound. But this exposure is invaluable in that precious metal offers powerful countercyclical and defensive capacities. So, when markets correct (as they will do many times over a multi-decade horizon), this offers downside protection and dampens volatility. In this way, when a market recovery happens, the portfolio’s growth starts from a higher base. This “protection of the base” is a fundamental factor in compounding.

Investment principles remain timeless

To paraphrase D. Muthukrishnan CFP®, while investors want 1+1+1+1+1+1+1 = 7; markets inevitably deliver 1+2+4-3-2+0+5 = 7. No particular financial product or strategy will solve that problem. Ultimately, results are driven by purchasing good assets at good prices and ensuring that returns compound to protect and grow your wealth.

Even as we continue to see pioneering new financial innovations and products appear, certain investment challenges and principles remain timeless. Investors need to know what they own to understand what risks they are taking, and what forces and elements are influencing their investment outcomes. And they need to know if this strategy will deliver the results needed to meet their investment objectives.

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