Diversifying your portfolio to weather market ‘down days’

Patrick Hodgens

Firetrail Investments

Investors received a timely reminder yesterday that equity markets do not always rise. For only the second time this year the Australian equity market fell by more than 2% in a day, returning -2.7%. The only larger daily decline this year occurred on February 6 when the market fell -3.2%.

Over the long term, the Australian equity market has been a great investment. In fact, if you had invested $100,000 in the S&P/ASX 200 Accumulation Index 20 years ago, it would now be worth over $470,000 today. However, with markets at all-time highs, we believe now is the time to add an uncorrelated source of investment returns to your portfolio.

The largest drawdowns over the past 20 years

Equity markets can be volatile. Despite being a great investment over the long term, there have been significant drawdowns as highlighted in the chart below.

The largest drawdown was the Global Financial Crisis (GFC) when the Australian market fell over 50%. These significant falls can have a severe impact on your portfolio’s returns and can take a long time to recover from. The market took over five and a half years to recover from the lows of the GFC.

The key question investors may be asking is how do I avoid these significant market drawdowns. Some investors try to time the market and move between equities and cash. However, in over 30 years investing in equity markets I am yet to come across an investor who can time the market with the accuracy and consistency required to add value.

One of the great investors of our time Peter Lynch sums market timing up wisely, “Far more money has been lost by investors preparing for corrections, or trying to anticipate corrections, than has been lost in corrections.”

Diversifying your portfolio to weather market ‘down days’

Rather than trying to anticipate the next market downturn, a far more prudent approach is to mix in a portfolio of uncorrelated assets that can weather different market environments. Adding alternative investments to a diversified portfolio is also a good way to hedge your portfolios exposure equities and provide an alternative source of returns.

In our experience managing market-neutral strategies, you can diversify your portfolio for the ‘down days’ by adding alternative strategies to your portfolio that mitigate two key risks prevalent in equity market investing:

  1. Market risk - Reducing your portfolios net market exposure to zero at all times ensures portfolio returns are not affected by market movements
  2. Macroeconomic risk - Reducing your exposure to unpredictable macroeconomic risks such as interest rate movements, currency fluctuations or political decisions is key to reducing the volatility of your portfolio’s returns. Whether and when the China/US trade war is resolved or predicting interest rate rises are binary bets that can either significantly amplify or reduce portfolio returns. In our view, you need to reduce your exposure to these key risks and focus on investing in companies from a fundamental perspective, rather than unpredictable macroeconomic themes.

Market Neutral – An alternative to cash and equities

One alternative for investors that still want exposure to companies but want to reduce the impact of the daily market volatility is to invest in market-neutral equities funds. Market-neutral funds are an ‘alternative’ investment strategy that invest in individual shares but hedge their exposure to the underlying share market with a portfolio of short positions that are equal to their long positions.

The result is that the portfolio has zero net market exposure through time (although this can vary from fund to fund). Which means that the returns of the portfolio are not impacted by movements in the underlying share market. The key advantage of market neutral strategies is that you still have exposure to individual securities, however it is stock selection (on the long and the short side) that is the key driver of returns as opposed to the direction of share markets.

Yesterday, when the market fell 2.7%, having some exposure to true alternative investment strategies such as a market neutral fund could have provided some much-needed diversification for many investors’ equities portfolios. With markets at all-time highs, we believe now is the time to add an uncorrelated source of investment returns to your portfolio.

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For further insights from the team at Firetrail Investments, please visit our website


Patrick Hodgens
Portfolio Manager
Firetrail Investments

Managing Director at Firetrail Investments as well as Portfolio Manager for the Firetrail High Conviction Fund and the Firetrail Absolute Return Fund. 34+ years’ experience investing in equity markets.

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