Diversify, diversify, diversify

While we in the UK have an admirable history of equity investment, very few financial advisers these days recommend full equity allocation, even for savers at an early stage in their careers.

It is easy to see why, as investing in an all-equity portfolio, in particular in equities of a single country, carries significant short to medium-term risks. During market downturns, stocks can be penalised irrespective of underlying company fundamentals.

The FTSE 100 index has experienced several major setbacks since its inception in 1984, falling -47.9 per cent after the dot-com bubble and -40.6 per cent after the global financial crisis.

Longer data analysis obtained from the Barclays Equity Gilt Study indicates that there have been six periods since 1899 when the UK equity market took at least five years to return to its pre-bear market levels (1910-18, 1937-45, 1947-53, 1972-78, 2000-07, 2007-13). In the worst two cases, 1910-18 and 1937-45 – periods bookmarked by war – the recovery took nine years.

In the modern-day context, these are unacceptable periods of nil or negative returns for all but guardians of multi-generational wealth.

Despite the frequent references to theory about investing for the long term, these oft-expressed desires are largely unconsummated.

Despite the frequent references to theory about investing for the long term, these oft-expressed desires are largely unconsummated

Last month, the Government instituted compulsory occupational pensions, further proliferating investment need and activity. With proliferation comes the quite understandable desire to avoid negative outcomes, an instinct most keenly felt by financial advisers, who face their clients and the regulator.

As a consequence, there is a general incentive to de-fang the equity market. The potential for capital gain or loss in an investment is the definition of risk, and risk is often proxied by measurement of volatility of historical returns. Risk and return are interlinked, where conventionally higher risk is associated with greater probability of higher returns, and vice versa.

The table below shows the real returns (after inflation) of a selection of UK assets over the past 116 years. The FTSE 100 produced a 5 per cent annualised real total return compared to 1.3 per cent for UK gilts over the full period, achieved with almost twice the volatility (20 per cent versus 12 per cent). However, it may not always be the case that one is compensated for taking on more risk.

Source: Barclays Capital Equity Gilt Study

As we can see from table A, while over the long-term equity returns easily outperformed bonds, the risk return trade-off between the two has not been a great one over the more recent 20-year period, where equities underperformed bonds even though their volatility remained much higher (15 per cent versus 8 per cent).

It is at this point that multi-asset strategies come into play. Through asset allocation, an investor has the flexibility to navigate the risk-return profile between different asset classes and seek a better risk-adjusted return for their portfolios. The concept is not a new one: a balanced portfolio of equities and bonds is an early form of this model, and is still widely used to date. Multi-asset investing takes the balanced model further, by introducing other allocation options such as gold, commodities, infrastructure, real estate, hedge funds and derivative overlays.

The main benefit of a multi-asset portfolio is diversification: the avoidance of possibly harmful concentrations. An expanded tool set allows the potential for professional investors to select prospective assets and position appropriately, adapting to changing market conditions at will. This should result in a less volatile portfolio, the direct consequence of diversification.

A simple exercise examining the risk-return profile of model multi-asset portfolios also helps to illustrate this.

In table B, below, Portfolio 1 is the 100 per cent equity option, and from this base case, we create six equally weighted portfolios, adding international equity, gilts, absolute return, property and gold to the asset mix, using monthly data from 1998-2016.

While this is by no means a comprehensive test, the general conclusion from this exercise shows that the addition of other asset classes does tend to lower the volatility of the portfolio, despite some of these assets (that is, property) having higher volatility, measured in isolation, than the equity market. It also shows that it is possible to achieve higher returns with a similar or lower level of volatility through diversification.

It is also worth noting how the volatility of the assets changes under stress. If we look at the 12-month rolling volatilities for the six portfolios and the asset classes individually, we can see that equity portfolio volatility (portfolios 1 and 2) climbed in 2008, as expected, but the volatility of portfolios 5 and 6 also surged massively, pushed up by property exposure. This highlights the importance of the need to (factually) to understand how assets have behaved under different market environments in the past and (imaginatively) how they might perform in the future. Correlations are not stable phenomena.

This approach is not free of caveats. By introducing more variables, the complexity of the portfolio is increased and asset allocation, on which returns depend, is an active process, therefore subject to error. Even those who claim to dodge the fallibility of allocation by notionally adopting a passive approach are active decisions. For who determines why a 50-50 bond/equity portfolio is adopted but a human?

The Dutch invented equity investment, with the promulgation of the joint stock company, and we in the UK quickly adopted their model. The traders who did so were buccaneers, prepared to lose all to gain a lot. We retain some of the instincts of our forebears but little true appetite for the untrammelled range of investment returns. In today’s world, the match between investor desire – with its skew to avoiding deeply negative outcomes – and investment manager is best achieved by following a multi-asset approach.

James Spence is lead portfolio manager of TM Cerno Select, a global multi-asset fund and Fay Ren is investment analyst at Cerno Capital