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Portfolio diversification is key to weathering volatility

Fund managers must tap asset classes like commodities and bonds

Since the beginning of the year, the markets have been under significant pressure due to uncertainty over the short-term direction of oil prices and slowdown in global growth.
Moreover, a series of events, including divergent monetary policies from the world's two largest banks - the European Central Bank and US Federal Reserve, a slowdown in China, implications of the Iran deal and escalating regional conflicts, that all unfolded at regular intervals during the past six to eight months, have also not allowed the markets to either absorb or settle down.
As a result, the regional markets remained highly volatile during the past quarter and investors turned more cautious, preferring to liquidate part of their risky assets to minimise losses towards the end of the year.
Despite being the most diversified regional economy, the UAE was also not immune to the meltdown during 2015. The array of events led to increased volatility in the capital markets, impacting financial firms and real estate activity (both value and transactions) as both these sectors account for the majority of UAE portfolios.
The equity markets in the UAE felt the selling pressure on the back of weakening oil prices and an expected slowdown in economic activity. Dubai was down by 16.5 per cent in 2015 and Abu Dhabi by 4.9 per cent.
Liquidity pressure
The relative outperformance in Abu Dhabi was largely due to etisalat, which had appreciated after being included in the MSCI Emerging Market index. Both the UAE indexes were dragged lower by the financial and real estate sectors. Banks in the UAE started to feel liquidity pressure, while real estate came off its peak due to a mix of domestic factors and selling pressure from foreigners to capitalise on the expected recovery in the developed markets.
Given the current investment environment in the UAE and volatility in financial markets, active portfolio management can help in mitigating risk and minimising losses. Accordingly, it will be important for the portfolio and asset managers to diversify their portfolios into other asset classes such as commodities, bonds and private equity. This will enable them to realign their existing portfolios (equity and real estate) and reduce volatility to reflect the underlying pillars of the UAE economy (retail, hospitality, aviation, tourism, etc.).
Additionally, investors who have liquidated their holdings during the last quarter of 2015 should utilise this period to start allocating capital into risky assets on a gradual basis in the current market environment.
Considering the current market environment, an optimal portfolio allocation would comprise equities (20 to 30 per cent), alternative investments, including real estate and private equity (30 to 40 per cent), bonds (10 to 20 per cent), commodities (five to seven per cent) and cash (10 per cent).
Additionally, it is also important to consider the duration of the investment and stage of the investment cycle as it will provide a clear perspective for long-term investments.
A balanced mix
In equities, the sharp decline seen in the UAE during 2015 presents investment opportunities for long-term investors as valuations have come down to more compelling levels. However, the uncertainty in global markets and direction of oil remains a concern, hence the equity portfolio should be a mix of cyclical and defensive sectors.
In the defensive space, consumption-driven sectors such as education, healthcare and F&B will continue to witness healthy earnings growth and also payout dividends going forward.
In the cyclical sectors, banking and real estate sectors should be picked based on company-specific fundamentals, especially companies with minimum exposure to debt and ability to deliver growth in current market environment. Additionally, companies with a history of paying dividends, especially banks with strong earnings growth, superior asset quality and adequately capitalised should be looked into more closely in the current market environment.
The real estate sector in the UAE has been under pressure in 2015. Foreign investors continued to sell their existing portfolios to benefit from the currency differential in their respective countries as the UAE dirham is pegged to the US dollar.
This phenomenon might continue in 2016 and prices might soften further but the demand and development in the real estate sector will continue, albeit at a slower pace. Moreover, rental yields in the real estate space continue to remain on the higher side. Given the Expo 2020 event to be hosted in Dubai, the demand for real estate will continue to remain robust as the country will witness an influx of inhabitants.
Private equity investment
Private equity activity was resilient in 2015. Moreover, the region in general and the UAE in particular continue to attract foreign investments as the government is committed to diversify its economy base through a mix of public and private participation.
Given the long gestation period, private equity investment as an asset class provides the stability and reduces the volatility in a well-diversified portfolio. Hence, investors must allocate part of their portfolio to private equity, however, investments should be focused on sectors that reflect the underlying strength of the UAE and part of the government agenda and five-year plan.
Bonds as an asset class offer stability to any portfolio through the risk reduction of steady stated payments. In the commodities space, gold has become an important asset. Gold is in a sweet spot in the current environment as it is likely to benefit both from dollar strength or any further deterioration in macroeconomic environment. Consequently, gold is increasingly considered as a safe heaven and has gained traction in the past three to four months. Hence, adding gold to the current portfolio will not only provide diversity but also deliver stable returns going forward.
In conclusion, active portfolio management aims to complement existing asset allocation while making the portfolio more robust in an increasingly uncertain environment. Therefore, rather than focusing on market turbulence, portfolio and asset managers should focus on developing a sound investment strategy for the next two to three years to reap the benefits of volatile market conditions.
The ability to adapt to a changing environment will be the key to success and those who can see beyond short-term volatility by focusing on the principles of active portfolio management will be rewarded for their patience and discipline.
The writer is founder and CEO of Al Masah Capital. Views expressed are his own and do not reflect the newspaper's policy.