Charities, like all investors, are contending with a new investment regime. We believe it to be a more hostile one characterised by higher and more volatile inflation. Traditional balanced portfolios suffered in 2022, as bonds and equities repriced on the basis of higher interest rates. Put simply, there were very few places to hide, and diversified strategies turned out to be not so diversified after all.
The game has changed – we have moved from a game of checkers to a game of chess. Conventional strategies – holding the right assets and being patient – will no longer suffice. Investors will need to be more active, willing to challenge market certainties, be able to dial risk up or down at short notice, and look to unconventional assets to provide genuine downside protection in more frequent market dislocations.
Nowhere to hide
Figure 1 shows the returns you could have earned across global stocks and bonds if you had a crystal ball which allowed you to pick exactly the best place to be invested each quarter. Over the decade to the end of 2021, you would have delivered a 35x return on your original investment. Looking further back, if you had started in 1980 with a portfolio of £100,000, this would have compounded to £4.8bn by the end of last 2021.
Yet, in 2022 even the best asset class has been a lacklustre performer. Equities, sovereign bonds, corporate bonds, infrastructure, property, private equity, private credit, venture capital and cryptocurrencies all posted negative returns. There has been nowhere to hide – and that is before adjusting for the double-digit inflation ravaging your capital.
We have called this the illusion of diversification. The balanced portfolio was not balanced. The assets investors believed to be diversifiers turned out to have higher cross-asset correlations than first thought. They all appear vulnerable to the same risks – rising interest rates and rising risk premiums, which both appear to be happening at the same time. The only place to hide in conventional assets was commodities.
We expect the coming decade to have similarities to the 1970s – a period of political, economic and inflationary turmoil – with all the market volatility investors rightly dread. Unfortunately, nobody has a crystal ball to guide them through the mayhem.
A new era of inflation volatility
The return of inflation has been painful for investors, and for charities contending with everrising liabilities. The hope is that we have reached peak inflation, and that it may now be on the way down. Sadly, however, that doesn’t necessarily mean the investment landscape is getting any easier.
We believe that structural forces – economic and geopolitical – have rendered more volatile inflation inevitable. The result is that over the short term, we are likely to see significant swings in rates and inflation which will mean investors will need to trade in and out of so-called duration assets – assets which are sensitive to changes in interest rates, like bonds or growth equities.
Prepare to be agile
To this end, the use of cash (counter-intuitively, in an environment of volatile inflation) will be a key determinant of portfolio success.
One of the biggest advantages of cash is that it gives you optionality, the option to move quickly and pounce on opportunities. Cash is a call option with no expiration date on every asset in the world. The expected return on cash isn’t the yield it gives you, it’s the return you will earn by being able to buy distressed or dislocated assets. For example, during the record-breaking volatility we saw in gilt markets earlier this year, it paid to be active when others weren’t. At the end of September, we were buying long dated index-linked gilts at extraordinarily distressed prices, just before the Bank of England stepped in to restore order. These gilts rallied 115% on the day. This was an opportunity that lasted not weeks, or days, but hours.
There are lessons here that show the power of holding cash and being able to deploy it opportunistically.
Firstly, in a behavioural sense. Being able to make decisions unencumbered by the pain of nursing hefty losses. Secondly, the ability to act as the market maker or buyer of last resort. If you show up to an auction and you are the only bidder, the chances of getting a good deal are much improved. Thirdly, holding cash is an acknowledgement that tomorrow’s opportunity set could be more fertile than today’s. When attractive situations appear, you can allocate in size. As Warren Buffett said: “When it’s raining gold, reach for a bucket, not a thimble.”
Tactics matter
So, the challenge for investors is to shift from a purely strategic approach (get the asset allocation right, and be patient) to a more tactical one. This will help deliver positive returns throughout variable market conditions. We see three key elements to this approach; the ability to hold cash (even when it feels uncomfortable), a willingness to pay to hedge against market dislocations, and the capacity to dial up risk at short notice.
This reflects a more complex and unforgiving investment landscape. A change of the game, from checkers to chess.
Ajay Johal is an investment manager at Ruffer
Charity Finance wishes to thank Ruffer for its support with this article
