Diversifying your portfolio requires more than just adhering to Regulation 28

"Diversity is strength." Nowhere is the aphorism more appropriate than in the world of investing. It is the principle that underpins Regulation 28 of the Pension Funds Act, which aims to protect people from poorly diversified portfolios by limiting how much they can invest in certain asset classes, particularly riskier ones, like equities, property and foreign assets.

Yet, one of the downsides of Reg-28 is that South Africans tend to regard their portfolios as sufficiently diversified by adhering to the legislated asset class caps (75% equities; 25% property; 30% offshore; 10% Africa ex-SA).

Often investors don't consider diversifying within these broader asset classes, particularly in fixed-interest securities. For example, an individual nearing retirement wanting to place a significant portion of their savings in a low-risk, income generating portfolio would likely look no further than an income fund or fixed deposit or money market account.

A five-year, fixed deposit investment at one of SA's major banks would pay interest of between 7.75% and 8.75% per year for someone 55 years and older, depending on the principal amount invested. An enhanced income fund, typically comprising 75% stable income-bearing assets like cash and bonds and around 25% "growth" assets like preference shares, listed property or international assets, would likely pay a premium above cash deposit rates of just over 1%.

While there's nothing wrong with either of these options for someone looking for stable, predictable returns, it is possible to diversify further within the fixed interest paying space to achieve the widest possible balance between risk and returns.

Participation bonds for instance, provide stable, fixed rate returns that are also backed by the underlying asset comprising mainly of commercial and industrial property. While income funds have exposure to listed property as well as preference shares or corporate bonds, they are exposed to the balance sheets of the entities underpinning these securities.

Participation bonds on the other hand earn their income from mortgage payments of the underlying commercial properties, which are underpinned by the market value of these brick and mortar assets. In addition, they are legislated by the FSCA and Collective Investment Schemes Control Act, which stipulate that the ratio of loan to property value can never exceed 75% (i.e. the combined value of mortgages on the underlying properties can never exceed 75% of the combined property values). This provides an inherent 25% buffer to any investor worried about a worst-case scenario in which property values might sink below their loan value.

Historic returns on participation bonds have averaged roughly three percentage points above the prevailing consumer price index (CPI), making them ideal for people nearing retirement.

So why haven't South Africans been more receptive to alternative investments? This is at least partially explained by the inherent conservative nature of South African investors and, by extension, money managers.

Despite the fact that Reg-28 upped its allocation to alternative assets to 15% in 2011, from 1.5% previously, local money managers still allocate less than 2% of assets under management to alternative assets, compared to 29% in the US and 24% in Europe.

Additionally, South Africa's equity market has been the best performer worldwide in the 117-year period beginning 1900, delivering an average annual return of inflation plus 7.2%. What's more, that performance is in dollar terms! With equities performing so well there just hasn't been a reason to look at alternative asset classes.

Yet, with equity markets across the world hovering near all-time highs we're heading into unchartered waters with many predicting a prolonged period of more moderate performance, or even a sustained bear market. This is where alternative, income-yielding assets could come into their own. Thanks to technology, the world of alternative investments is taking a truly innovative and diversified turn. Investors are starting to investigate options as varied as agricultural farming and renewable energy, all delivering attractive returns.

If there is one key message it is this: don't fall into the trap of thinking that you are sufficiently diversifying your portfolio merely by adhering to the stipulated asset class caps. There is a lot of scope for further diversification within asset classes and by ignoring this you may be forfeiting exposure to some unique asset classes that pay solid returns with very low risk.