Growth portfolios have historically been dominated by high equity exposure. The general belief amongst the investment community is that higher equity exposure will deliver higher returns over time. Although we view equity exposure as important in a portfolio, we regard true balance between beta sources as more important from a risk adjusted return point of view. We think that most investment portfolios are too equity dependent for its returns. This can be improved upon by diversifying more effectively.
Example: The classic balanced portfolio (60% equities/40% bonds) can be improved upon by reducing its equity exposure in favor of commodity exposure (40% equities, 20% commodities and 40% bonds). This strategic inclusion of commodities delivers similar long-term returns than a traditional balanced portfolio but is superior on a risk adjusted return basis. We regard exposure to commodities as crucial from a strategic point of view based on the diversification value it adds to equities and bonds within a total portfolio.
The difference between a classic equity centric balanced fund and a more diversified balanced fund, with a strategic 20% allocation to commodities, is significant as illustrated above. The reduction in equity exposure for more commodity exposure, reduced the volatility from roughly 10% per annum to 8% per annum. What is even more significant is the reduction in the maximum draw down from –23% in the traditional portfolio t0 –11% of the effective portfolio. All these risk reduction measures manifested whilst the more effective portfolio delivered better returns than the traditional balanced portfolio. One additional beta source proofed to add value based on the additional diversification value which resulted in a more balanced and ultimately effective portfolio.
We also believe that active management in conjunction with an effectively diversified portfolio can enhance the risk adjusted return characteristics of a portfolio even more. Click here to read more about our views on active management.