Article By Kieran Degiorgio
Recent developments in the Middle East have prompted volatility across global financial markets as the repercussions of the higher repricing in oil, trading at around $90-100 per barrel, are continuously re-assessed and reflected in forward expectations, and hence, in market pricing.
The threat of higher inflationary pressures has resulted in weakness across global fixed income with yields repricing higher. Corporate debt has thus far remained, broadly speaking, resilient, both in terms of market performance and valuations, with this being more evident amongst the upper echelons of credit quality. The dampening of risk sentiment has manifested in a moderate pullback across major equity indices over the past weeks, while the US Dollar has been a beneficiary of ‘safe haven’ flows, resulting in a modest strengthening versus other major currencies and exerting pressure on gold and silver.
The duration and magnitude of such conflict are unclear, with my guess being as good as anyone else’s. We are, however, reminded about one of the key principles of portfolio and wealth management, especially relevant during turbulent times - diversification.
Investing isn’t solely about the return one generates on invested capital, but also, and equally as important, about the level of risk one is exposed to, normally measured by the volatility of returns.
It is as such imperatively important for investors to manage risk through a well balanced and diversified portfolio, with this, when done well, promising lower levels of volatility, limiting damage during periods of downside along with bolstering risk-adjusted returns.
Diversification, at face value and from a top-down perspective, can be achieved by being invested across a variety of asset classes, such as equities, sovereign and corporate debt, along with real estate, commodities and alternative investments, with relevant allocations between such being highly dependent on an investor’s return objectives and risk preferences.
Being invested across a variety of economic sectors, industries and geographies also helps in the construction of more resilient investment portfolios. From a bottom-up perspective, investing in a larger number of different instruments, maintaining small individual position sizes relative to the portfolio’s total market value, along with managing concentration ratios are all steps in the right direction towards better diversification.
The above can also be accomplished via the use of investment funds, both passive and active, which in most cases carry a multitude of separate underlying investments, bypassing implementation hurdles faced by portfolios which are smaller in monetary terms.
Diving deeper, one can also take a more quantitative approach, analyzing correlations between different portfolio holdings via correlation matrices. Portfolios can, sometimes, look diversified at first glance, but behave in a concentrated manner, and be highly reliant on a specific theme, macro-economic variable or another asset’s price movements.
Some simple examples. Being invested in shares of Volkswagen AG and Mercedes Benz Group AG, while two different companies with differing fundamentals and forward expectations, presents considerable overlaps, with these both operating in the same industry and country, amongst other considerations. Surpassing the geographical barrier, being invested in shares of Chevron, Shell and Eni, some of the world’s largest oil and gas producers, will inevitably tie portfolio performance, to one degree or another, to movements in the spot price of such commodities.
Looking deeper into a portfolio’s underlying exposures and sensitivities along with cross-asset correlations is as such advisable, with assets having a low or negative historical correlation amongst each other bolstering diversification.
In addition, a more holistic approach would be for an investor’s main sources of income and other assets to be taken into consideration, weighing both financial and human capital. This is especially relevant in the local context, whereby popular real estate investments pose concentration risks, raising the need for international diversification.
While in the words of Warren Buffett, ‘diversification may preserve wealth’, it is not a fix-all solution. The current oil-induced threat of stagflation, that is relatively low economic growth accompanied by relatively high inflation and unemployment, clearly reiterates this, creating a challenging market context with simultaneous weakness across a variety of assets. For the average investor however, as the saying goes, it is sound to not put all your eggs in one basket.
Kieran Degiorgio is a Senior Portfolio Manager and Research Analyst at Curmi & Partners Ltd.
The information presented in this commentary is solely provided for informational purposes and is not to be interpreted as investment advice, or to be used or considered as an offer or a solicitation to sell/buy or subscribe for any financial instruments, nor to constitute any advice or recommendation with respect to such financial instruments. The Energy Sector is not regulated by the MFSA. Curmi & Partners Ltd, with registered address Finance House, Princess Elizabeth Street, Ta Xbiex, Malta XBX 1102, is a member of the Malta Stock Exchange and is licensed by the MFSA to conduct investment services business.