Diversification: the key to making volatility work for you
“…Investing in small caps is rather like handling an electric wire, requiring a temperament capable of withstanding the shocks dealt by the perpetual ebb and flow of the market…”
Investors in small caps should know better than to expect a quiet life. The high returns that can undoubtedly be secured from the turbulent seas of the junior markets do not come easy. And the squalls of the past 18 months have been exceptionally severe. But here we suggest that – ultimately – volatility is the investor’s friend.
An exit strategy ensures trades are closed, successful or otherwise, on the investor’s own terms, rather than in response to rapidly changing conditions
The most recent annual update to the Numis Smaller Companies Index (NSCI), which has tracked the bottom 10pc of the UK market by value since the mid-1950s, makes plain just how tough things have been lately. The NSCI fell by 16.3pc last year, and the AIM All-Share fared worse still, shrinking by 31.1pc. AIM performed strongly in the wake of the pandemic, more than doubling in the 18 months to September 2021. But it has since fallen by more than a third, scrubbing more than six years of gains. Like tech-heavy indices such as the NASDAQ small cap markets weighted towards speculative growth stocks have been hit particularly hard by interest rate hikes. And small companies do not offer the dividend streams to which many investors turn in tough times.
As the saying has it, the price of making money is losing money
As in the aftermath of any storm some are able to find rich pickings amongst the wreckage. Many good small companies with strong cash flows and robust earnings are trading at multi-year valuation lows and single-digit forward earnings multiples. The Numis report highlights the opportunities offered by the unusually high number of ‘fallen angels’, companies that have plunged from the mid-cap or large-cap indices to the smaller markets, which now account for an unprecedented 26pc of the NSCI. And of course, amidst the churn, some stocks have risen while others have fallen, energy shares being the obvious example, performing strongly against growth assets such as biotechs.
A tougher market environment
These, however, are bright spots within the frame of a gloomy picture that presents a test of resolve even for the hardened investor. And the scene is likely to be murky for some time to come. As we noted in our recent article on commodity stocks investors are trying to come to terms with a harsh new environment in which the supportive monetary policy that has prevailed over the past few years is being unravelled. We are moving from a world of quantitative easing (QE) to one of tightening. Much of the tide of money pumped into the global financial system by central banks in the following the banking crisis and during the pandemic washed up in financial assets, floating many speculative assets that have since sunk below the waves.
Anne Walsh of Guggenheim Partners Investment Management suggests that we ‘are now in a consolidation period that marks the end of a secular bond bull market that lasted more than 35 years. This period will be characterised by reduced market liquidity, capital rationing and persistent volatility in asset prices.’ Or in brief: ‘The days of making easy money during QE are over.’ And since 2008 the world has been turning away from the trend towards rapid globalisation that made for a benign market environment during the long years of the so-called ‘Great Moderation’ that begun in the 1980s. Another chief investment officer, Sonja Laud of at Legal & General Investment Management, suggests we have entered a period of ‘ “slowbalisation” if not outright deglobalisation’. The rapid integration of the world’s markets in the years leading up to the financial crisis facilitated lower production costs and productivity gains that pushed inflation down, giving policymakers scope for low interest rates. Since then the process has fractured, cracked by rising political populism, tension between the US and China, and shocks like the pandemic and the conflict in Ukraine.
Small cap outperformance over the long run
But, hard as it is to absorb during tough times, the investor’s hardest won lesson is that volatility is the price of growth. As the saying has it, the price of making money is losing money. And that is particularly true when it comes to small caps. Several TMS articles have presented the plain evidence: staying the course with the junior markets rewards the patient long-term investor. Our most recent piece on this theme, published last June, drew on a battery of statistics to make the case for their long term outperformance.
To briefly recap some of the most striking figures: As our article discussed, small cap specialist Gervais Williams notes that £1 invested in 1955 in (what is now called) the MSCI All-Equity Index, would – with income reinvested from dividend payments – have grown to £1,070 by the end of 2013, a yearly gain of just over 12pc. Small caps have done better: over the same period £1 invested in the NSCI would have returned £4,907, an annual 15.5pc. But – remarkably – the same £1 invested in the ultra-small world of the MSCI World Micro Cap Index would have appreciated to £21,585. The smaller the company, the better the long term performance, and by some way. And illiquid small caps do even better. The returns generated by the most actively traded 25pc of securities on US markets from 1971 and 2012 was considerably lower than that of the least traded quartile. The differential between the performance of the most liquid stocks and the least liquid stocks – which tended to be micro-caps – was more than 14pc on average each year. We can zoom in yet further. Small illiquid small caps with classic value characteristics – low price/earnings and high price-to-book ratios – do better yet. While £1 invested in stocks at the bigger end of the NSCI from 1955 to 2013 would have returned £2,600, smaller stocks with value characteristics would have returned more than £61,000, an average growth of 15pc a year.
It seems, then, that understandable bias against investing in small, fiddly, illiquid stocks means that many strong performers are overlooked, opening opportunities for those prepared to trade them. But there remains the further challenge of volatility. Investing in small caps is rather like handling an electric wire, requiring a temperament capable of withstanding the shocks dealt by the perpetual ebb and flow of the market.
In The Long and the Short of It, a shrewd guide to the intellectual and psychological challenges of investment, veteran commentator John Kay suggests we can better cope with volatility by adopting the correct attitude to risk. Kay rejects the common investment advice to think of risk in terms of short-term volatility of yield: the supposed trade-off between risk and return. Rather, we should understand risk in its everyday sense, as the concern that things will go wrong and prevent us from meeting our objectives. For the investor the real risk isn’t the day-to-day – or even year-to-year – volatility of a collection of stocks, but the possibility that they do not yield the desired return over time. If the portfolio does come good, the turbulence it had to endure wasn’t risk at all, but the natural consequence of being set afloat in the markets. The real risk would have been selecting a ‘safe’ set of securities that performed less well over time.
Indeed, for investors, volatility is the engine that powers returns. This is the key insight of the principle of diversification that guides modern portfolio theory. As Kay puts it: ‘For the intelligent investor, risk is a characteristic of a portfolio, rather than of the individual security.’ Effective portfolio construction does not consist in assembling a group of assets, each of which might be promising in its own right, but in the judicious correlation of those assets. The evidence is that a portfolio comprised of individually risky investments is geared to yield a higher return than a collection of respectable blue chips prone to rise and fall together.
Kay presents a thought experiment indicating how a diversified portfolio comprising a set of individually volatile assets might pay off over time. Consider a collection of securities with a ‘risk premium’ of 4pc – the extra return investors might expect those assets to generate in compensation for the risk of holding them. And suppose that the standard deviation of annual equity returns is 15pc (approximately the historical average). In the very short term, say over the course of one week in unremarkable market conditions, there is almost a 50pc chance that a set of ‘risk-free’ assets will do better. But over a year, if the expected value of the additional return from volatile assets is 4pc the probability there will be some additional return to compensate for rises to around 60pc. Over a much longer time horizon, say 25 years, the divergence becomes much greater. Now the expected value of the ‘risky’ portfolio is 167pc higher. Over this long period day-to-day price movements look much more like market ‘noise’ than ‘risk’.
Here Kay is following the insights not just of Harry Markowitz, who pioneered the theory of diversification, but of the great value investors Benjamin Graham and Warren Buffet, for whom the capricious character of the markets is the condition of securing robust returns. A well diversified portfolio is truly ‘anti-fragile’ as defined in Nassim Nicholas Taleb’s influential book, growing stronger when exposed to volatility. In Buffett’s words, ‘volatility is almost universally used as a proxy for risk. Though this pedagogic assumption makes for easy teaching, it is dead wrong.’
How, then, to diversify effectively? We offered some thoughts in our series on trading the markets, but the essential discipline is to pay close attention not only to the appeal of individual assets, but how they are likely to mesh, how they pull and push against each other. It is not as easy as simply following a particular index, even a relatively diverse one like the FTSE 100 or the S&P 500. As recent history has shown so dramatically, when times are tough most of the shares in a particular index fall together, just as they tend to rise together in good times. A well diversified portfolio will mix stocks in radically different sectors, across multiple international indices, and across asset classes, incorporating fixed income and alternative securities as well as equities. To quote Kay again: ‘You can build an investment portfolio for a rainy day, but what of a monsoon? The only certainty you can have is that a well-diversified portfolio gives you the best chance that at least some assets will retain their value’.
This can be done quite effectively with a cheap ‘life strategy’ fund from one of the big investment institutions, which will mix equities, bonds, alternative assets from across the world. But those prepared to take a more active approach in search of higher returns can assemble an effective portfolio using appropriate passive and active funds as building blocks, and, of course, by selecting individual stocks. With diversification in mind that involves not only paying attention to the fundamentals – a solid business model, competitive advantage, robust finances, engaged management and so on – but also due regard to correlation. Investors who had held on to oil and gas stocks at the height of the pandemic would have been rewarded last year. And those who went all in on tech stocks would have given up most or all of their gains. The permutations are endless: Kay’s book is just one of many good resources that teaches the principles.
In assembling a diversified portfolio investors should also follow the kind of essential risk management principles we covered in our series on trading the markets. As we noted, without a plan decisions will be made on the hoof in response to events. Profits may be taken too soon, or more likely, wither on the vine. An exit strategy ensures trades are closed, successful or otherwise, on the investor’s own terms, rather than in response to rapidly changing conditions.
Trusting in what works
During fallow periods, like now, the principles of disciplined portfolio construction can seem rather abstract. But they have proven themselves as time-honoured fundamentals for securing long term returns. A well designed diversified portfolio can make volatility work for you. And a portfolio weighted towards small caps can drive outsized returns – over time. As ever with investment, the basics can be quite simply stated. The greater challenge is to absorb them, to stick with them when times are tough and wait for them to work, as they have done before.