- Market drawdowns can be expected from time to time. Even drops of 10% or more aren’t that rare.
- We typically rebalance after large price movements to maintain the target asset allocations in our portfolios. The recent price moves have caused us to rebalance some of our portfolios.
- However, we have not adjusted our portfolio target allocations as a result of the downturn driven by coronavirus (Covid-19) for two main reasons. First, we believe these latest price movements to be driven by sentiment—investors’ feelings—rather than by long-term fundamentals.
- Also, we have been conservatively positioned for some time because we’ve had a dim view of the aggregate risk/reward picture for global stocks. Even declines of 10% or more haven’t brought most asset classes into pricing territory we find attractive.
- We are assessing buying opportunities brought on by the declines, but again most asset classes haven’t lost enough to become attractive.
Drawdowns Are Expected
Once again stock markets are dominating the headlines, as concerns about the economic impact of Covid-19 draws the focus of investors from the long-term horizon to the here and now. In these situations, it is natural to ask how your investment manager is responding and thinking about the risk and opportunities created by this market movement.
It is easy for investors to react to alarming headlines and to panic when events such as this outbreak occur. However, we believe that taking a more measured approach is key at this time, directing attention to assessing the economic impact of events on the long-term fundamentals and valuations of asset classes.
The first point to note is that we expect periodic drawdowns and reflect this in our portfolios accordingly—that is, we seek not to optimize portfolios for one possible scenario but rather to build portfolios to be robust in any scenario. Within this context, the returns of our portfolios have remained within our expectations. We can therefore use these situations to focus our attention on looking for opportunities to improve the expected returns of the portfolios.
Second, sharp moves in the price of investments change the balance of the portfolio. For example, if 50% of a portfolio falls by 10% and the other 50% rises by 10%, the portfolio will have 5% more in the rising asset than before the price move. Left unchecked, this results in the investor owning increasing amounts of the asset that is becoming more expensive and less of the one that is becoming cheaper. To address this, we monitor drift in portfolios closely and ‘rebalance’ portfolios to ensure that they remain in line with our desired exposures. As ever, you will receive notification of these rebalances as they happen.
Why We Haven’t Changed Targets
We have and expect to continue to rebalance portfolios after prices changes like the recent ones. However, we are yet to change the target composition of the portfolios, for two primary reasons. First, we prefer to base decisions on our ongoing, in-depth fundamental research rather than on knee-jerk reactions. As you would expect from us, the focus of this research is understanding the potential for change in the expected return of assets over the long term, rather than near-term price movements. This longer-term perspective enables us to compare the current price to a realistic appraisal of an asset’s fair value and use this comparison to identify assets that have become either unusually cheap or expensive. This in turn, enables us to improve the overall expected return by increasing exposure to the former and reducing it to the latter.
And a long-term perspective is important at these times, as investors are becoming increasingly concerned about the economic damage caused by the spread of Covid-19. While there are many ways this virus can impact the assets in which we invest, it is important to separate permanent damage which will impact the long-term fair value of an asset from temporary damage which will quickly be forgotten.
Numerous epidemic outbreaks in the past have led to short-term losses in global equity markets. However, these losses have tended to be recovered relatively quickly, suggesting that sentiment has been the main driver rather than a longer-term economic impact. Whilst it is too early to assess if this outbreak will have a long-lasting negative impact on economies around the world, to date we believe the evidence points to a short-term impact (assuming health officials are successful at containing the outbreak).
If the impact is short-term, price declines may produce buying opportunities. Warren Buffett, chairman and CEO of Berkshire Hathaway, said early last week that “you don’t buy or sell (a) business based on today’s headlines. If (the market) gives you a chance to buy something you like and you can buy it even cheaper, then it’s your good luck.” Some asset classes appear attractive to us through this lens, most notably energy stocks and UK equities, however others continue to remain unattractive despite the recent falls. It is therefore important to be selective when making changes to portfolios. It is for this reason that we monitor more than 250 asset classes each month and our 100-strong team of investors spend most of their time doing deep research on potential investments to improve the characteristics of our portfolios.
Make no mistake: The human toll paid to Covid-19 has already been unacceptably high, and our hearts are with the sufferers of this virus around the world. As investors, however, our minds remain on what we believe is most important when investing—namely, balancing risk and reward and coaching ourselves and others to make good decisions.
As ever, we are grateful for entrusting your clients’ capital to us. We take this responsibility seriously as we look for investment opportunities to improve portfolios and guard them against un-remunerated risks. We always love to hear from clients and so please do let us know if you have any specific commentsorquestions.