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Reducing risk through specialised investments

Reducing risk through specialised investments
JOHANNESBURG - Investors looking to mitigate the downside risks in their portfolios no longer need to rely on traditional diversification strategies to achieve their goals

In times of heightened uncertainty, investors are constantly on the lookout for ways to reduce risk in their portfolios, while striving to still achieve their long-term investment goals.

This is a particularly pertinent issue for investors facing key landmarks in their retirement planning. A sharp fall in the market just before retirement can have a major impact on the value of a person’s portfolio, as one shifts assets into a post-retirement vehicle.

The textbooks tell us the best way to mitigate risk is through a well-diversified portfolio. A spread of asset classes (for example a portfolio containing a mixture of equities, money market instruments, real estate investments, bonds and commodities), geographies (to offset the currency risk of holding assets in rands) and economic sectors (for example a mix of financials, mining companies and tech) can go a long way to helping investors to achieve their goals.

The philosophy of diversification is simple: a core portfolio complemented by investments whose return profiles are uncorrelated with the core. To use a simple example, an investor might hold a broad portfolio of shares but with some exposure to cash, gold or bonds. 

Because equity market returns have historically not been correlated with cash, gold and bonds, these provide some protection during times of stock market weakness by either rising or holding their value.

Another example is to hold shares that are considered rand hedges – these shares will typically appreciate in value (in rands) when the rand weakens.

A well-structured portfolio using some of these strategies can go a long way to reducing risks in a volatile market. However, these strategies are not without their shortcomings.

Beyond traditional diversification
One problem is “diworsification” – investing in too many shares and asset classes that it ends up diluting performance over the long term.
Another example is that the investments made to hedge the core portfolio don’t always perform as expected. For example, during the 2008 financial crisis, global bonds did not provide protection against a falling equity market, with the two asset classes both coming under severe pressure at the same time. Similarly, equity market sectors with different fundamentals may also fall simultaneously during times of stress.

Given these potential shortcomings, modern investors are always on the lookout for new and effective ways to hedge risks affecting their portfolios, either through new opportunities or through instruments that provide clear, definable outcomes.

Thanks to market innovation, these strategies are becoming increasingly available to investors.

Investors can now invest in structures designed to deliver certain targeted outcomes, according to market conditions, using underlying derivatives or other market instruments. Structured products and notes are good examples and will typically reference an underlying index to provide geared upside, while offering a degree of capital protection (often 100%).

Other investments provide access to asset classes and sectors that are not easily accessible on global exchanges, into the so-called “alternative investments”. Good examples of alternative investments are private equity, credit and hedge funds. While not typically liquid asset classes, they may suit certain investors looking for different ways to diversify their investments or portfolios. Others may provide access to parts of the investment market not generally available to investors.

Healthy risk through innovation

One of the challenges faced by wealth managers today is accessing attractive returns without taking on excessive downside risk. This is often offered in innovative investment solutions that leverage structuring and trading expertise and offer opportunities to investors in an investable fund format, says Glen Copans, from Investec Specialist Investments.

“The first of these is designed to give investors the benefits of equity market participation while protecting against major downside movements in the market as well as limiting the impact of smaller, more frequent downside movements. These funds use structured product technology to achieve their goals and avoid the risks associated with active stock selection, asset allocation and market timing” adds Copans.

Said funds are ideal for investors who want equity market exposure, but without wanting to carry all of the downside risks. In an age of increased lifespans, this should suit many retirees who in the past would have remained in low volatility, high income type investments rather than pursuing more risky investments such as equities.

ANA (AFRICAN NEWS AGENCY)