Diversification can beat ghost of 1999

Although the current investment climate has similarities with the situation at the turn of the millennium, changes have taken place that allow investors to avoid making the same mistakes.

Mark Twain once said that history does not repeat but it does rhyme, and those with a good ear might just hear some recent market trends rhyming with another profitable year for investors: 1999. In that year, profit margins were also strong but were threatened by an inflation trend – then it was wages, today it is commodity/energy prices.

In 1999, investors had to be favouring dot.coms to be joining the party as many “old economy” stocks were left by the wayside. Today it is mining stocks and takeover candidates driving the market up as value stocks seem like the poor relations of investment opportunities.

But the real money in 1999 was being made by those playing the “greater fool” game – buying the most archetypal investments without any attempt to claim a valuation case in the hope that there would always be a greater fool to offload them to at a profit later on. In 1999 it was the Nasdaq, split caps and Softbank; today it is emerging market debt, Indian stocks and, er, Softbank again.

Of course, the point of Twain’s quote is that the past is never so clear that everyone is able to spot and avoid repeating mistakes. For all the worrying echoes of 1999 there are many points of reassurance right now: the overall market valuation looks okay against bonds, companies are not yet over-investing, and the lagging parts of the global economy – Japan and Europe – seem to be expanding nicely.

Nonetheless, after three strong years from equity investing, the prospective returns are declining and the risks are edging up – the ideal time to increase portfolio diversification. But is there any way of reducing exposure to equity market direction without just bailing out and owning low-yielding cash and bonds?

This is where something really is different this time. The past seven years have seen significant changes in the tools and techniques available to investors, greatly expanding the range of investment choices customised for clients’ requirements.

The first area is a familiar one. “Skill-based investment” means fund managers aiming for returns above cash using good decision-making rather than just holding the market with a tilt. The advantage should be a source of return that avoids the rollercoaster of the stockmarket. The disadvantages have been finding a significant source of skill in the first place given the general efficiency of markets, and the lack of transparency and cost of the traditional skill-based funds: hedge funds.

The recent introduction of the Ucits III rules governing investment funds has changed all that overnight. A Ucits III fund can use a wide range of skill-based investment strategies within a familiar, liquid, daily-priced fund. For example, “global tactical asset allocation” refers to a strategy that exploits undervalued and overvalued equity, bond and currency markets anywhere in the world to add value. The inefficiencies between markets over time and across currencies create an excellent source of returns for specialist managers.

The second new area is the wider use of derivatives to create new fund payoffs. For example, a new fund on offer in the market begins with some active equities selected by an active quant process. To boost yield it then gives up some potential upside on each stock each quarter in return for extra income – covered call writing. Finally, it holds some lower-risk convertible bonds, offering equity participation with bond-like risk.

This cocktail provides a net yield of more than 7% while cutting the reliance on equity market capital gains. Otherfunds are taking different combinations of equities, alternative asset classes and derivatives to generate fund risk, return and income profiles to suit the specific needs of different customers.

Even the index fund managers are getting in on the act. The recent launch of two “fundamentally weighted” indices by FTSE – GWA and RAFI – claims to provide benchmark indices that avoid overpaying for expensive stocks. The theory is that stocks are quite often mispriced and that conventional indices that weightstocks by market cap will by definition put too high a weight on overpriced stocks and too little on underpriced ones. These indices weight stocks by non-price factors such as revenues, which history suggests can create indices with higher returns with less downside in periods of market declines, albeit with higher turnover.

It has been a great three years for investors in equities, but with prospective returns falling and risks edging up, this should be an ideal time to increase portfolio diversification. Unfortunately, equities, bonds, property and commodities have all done well, ensuring yields are low everywhere. But the arrival of new investment strategies gives investors another way to reduce their equity market risk without locking into very low interest rates.

Each new approach has advantages and disadvantages, and each investor’s different requirements and risk tolerance means one size cannot fit all. But the experience of 2000 suggests that the bigger risk may come with betting everything on the trends of the past three years continuing. As George Santayana, an American philosopher, once said, those who cannot remember the past are condemned to repeat it.