The pandemic, inflation, geopolitical tensions and changes in monetary policy have put the principles of asset allocation to the test. For Andrea Cavadini, the answer does not lie in predicting the next crisis, but in building portfolios that are robust enough to withstand a range of scenarios.
In recent years, investors have weathered a succession of crises. Have we learnt to manage risk better, or have we simply become accustomed to these uncertainties?
I am not convinced that these uncertainties are any greater today than they were in the past. During our careers, we have experienced the 2008–2009 crisis, which called into question the soundness of the financial system and even the safety of deposits. Crises have always been a feature of the markets. Today, however, news and share prices react more quickly, whilst the flow of information amplifies the perception of risk. From the pandemic to the war in Ukraine, we have seen rapid market corrections, often followed by sharp recoveries. We cannot optimise a portfolio based on the next geopolitical event, as we do not know which one will occur. Instead, we must build it in such a way that it can withstand a range of scenarios.
For decades, diversification between shares and bonds has been a cornerstone of wealth management. Is this still sufficient?
No; if applied mechanically, this approach is too simplistic. Supply shocks – particularly in energy and commodities – have altered the dynamics of inflation. When supply contracts, central banks may be forced to raise interest rates, even when growth is under pressure. Under these circumstances, equities and bonds may fall in value simultaneously. For years, we regarded zero or negative interest rates as normal, when in fact they were a historical anomaly. Bonds retain their utility, but it is important to understand the risks they entail and their correlation with other assets during periods of market stress. Holding positions in two asset classes does not necessarily mean achieving true diversification.
When a client says, ‘I don’t want to lose money’, what should their investment manager’s first response be?
We must ask them what they mean by ‘loss’. Do they wish to preserve their nominal capital, protect their purchasing power, or accept temporary fluctuations in the hope of achieving a long-term return? These are different objectives. If they need to use all their capital in two years’ time to buy a home and cannot afford a nominal loss, we must make it clear to them that this money should not be exposed to market risks. Cash reduces volatility but does not protect against inflation. The strategy must be based on the client’s needs, their investment horizon and their actual ability to withstand losses, rather than on a generally expressed aversion to risk.
But what about the Swiss franc, government bonds and cash? Is there really such a thing as a safe-haven asset capable of providing protection in all circumstances?
No. Each of these safe-haven assets protects against certain risks, but not against all of them. In our view, gold primarily protects against a loss of confidence in currencies. Central bank purchases also reflect fears of financial sanctions and a desire to diversify their reserves. The Swiss franc may strengthen during crises of confidence in the eurozone, but not in every scenario. Its performance also depends on monetary policies and capital flows. Government bonds, too, serve different purposes depending on the context. During the euro crisis of 2011–2012, German government bonds, known as Bunds, could act as a safe haven. By contrast, buying a ten-year Bund in 2021, when its yield was close to zero, exposed investors to a high duration risk. Before choosing a safe-haven asset, one must therefore identify the risk against which one wishes to protect oneself.
Can a client’s behaviour become a greater risk than that of the markets themselves?
It can have a considerable influence. Finance is also a human discipline, as fear and enthusiasm influence decisions. If the owner of a flat were to see its value fluctuate on a screen every day, they might react much like an investor looking at their portfolio. That is why we agree not only on a strategy, but also on how we will manage volatility. In 2020, a client wanted to sell everything whilst the markets were near their lowest levels. We managed to convince her to stay invested, and she benefited from the recovery. In 2022, however, following the invasion of Ukraine, she decided to sell despite our discussions. The markets subsequently rebounded and we had to rebuild her portfolio. She had sold at an unfavourable time, though she did not necessarily incur a loss relative to her initial capital. The aim is not to judge decisions with the benefit of hindsight, but to help people understand the consequences of decisions made under the influence of fear.
Can staying completely out of the markets be riskier than continuing to invest?
A wait-and-see approach carries an opportunity cost that is often underestimated. There is always a good reason to postpone an investment, be it a geopolitical crisis, a central bank decision or the risk of a recession. If we wait for all uncertainty to disappear, we risk never investing at all. This does not mean we should remain invested at any cost, but rather that we should follow a coherent strategy and adapt it as conditions change. We must also avoid becoming entrenched in our own convictions. If an investment is not performing, we must be able to recognise it. Discipline must not turn into stubbornness.
Artificial intelligence, defence and gold: how can we distinguish a structural trend from a speculative fad?
A trend may initially be driven by sound fundamentals, before gradually becoming dependent on capital flows. Gold, for example, initially benefited from central bank purchases, reserve diversification and concerns about currencies. Subsequently, the speculative element gained momentum. When an asset rises sharply, it attracts those who fear missing out on an opportunity. The price then becomes, in itself, a reason to buy. We have always had reservations about gold, as it generates neither interest nor dividends. Our lack of exposure cost us during its rally, and we acknowledge this. No fund manager is always right. The key is to have a clear investment strategy, to understand its limitations and not to blindly follow the consensus.
Where does the added value of an independent fund manager lie compared to a major bank?
It lies in the freedom to make decisions independently and to take responsibility for them. The portfolios of major banks are often similar, particularly due to the influence of benchmark indices and internal processes. An independent fund manager, however, can demonstrate greater flexibility. Before 2021, we had decided not to hold any bonds. With yields close to zero, we felt the risk was not sufficiently rewarded. We preferred to hold cash rather than adopt a traditional asset allocation out of habit. This choice served us well when interest rates rose. Conversely, our lack of exposure to gold worked against us. Independence does not guarantee better results, but it does give the freedom to make decisions that would not necessarily be taken in a large bank. However, one must still be able to justify them and accept the consequences. The aim is not to stand out at any cost, but to uphold a coherent strategy rather than simply replicating asset allocations dictated by industry convention.
What is the risk that investors are most likely to underestimate today?
False diversification. A portfolio may contain securities from different sectors whilst still being dependent on a single economic driver. Take the case of artificial intelligence. Semiconductors, data centre infrastructure, electricity companies and uranium-related firms appear to offer distinct exposures. Yet many depend on growth in investment in AI infrastructure. If market expectations change, these assets may be affected simultaneously. Investors believe they have spread their risks, when in fact they have built a portfolio heavily exposed to a single theme. And when a theme is gaining momentum rapidly, it is often the clients themselves who ask to increase their exposure. The fund manager’s role is then to explain why an investment that is attractive in isolation may undermine the balance of the entire portfolio.
Does ‘false diversification’ also apply to financial instruments and cash holdings?
Absolutely. Some structured products promise attractive coupons, but their protection depends on specific thresholds. During market corrections, significant losses may arise, as well as difficulties in reselling these products on favourable terms. It is not enough to look at the coupon: one must understand the overall risk profile. The same applies to private markets. When a fund holds assets that are difficult to trade, we cannot assume that redemptions will be possible in all circumstances, regardless of the terms set out by the vehicle. When we construct a portfolio, we do not simply add up the asset classes. We examine the risks to which the various positions are exposed, their potential reaction to a shock, and the volume of liquidity actually available. Diversification must be genuine, not merely apparent.