Diversification, but not as you know it

Diversification is when investors benefit from assets performing in different ways at different times to balance overall portfolio risk and reward. The key behind diversification is the way assets behave or, in other words, how they correlate to each other.  

Traditional assets, such as government bonds and equities, are a good example of two assets that have behaved differently and have experienced a negative correlation, so when one asset rises in value, the other falls. This balancing effect helps improve portfolio risk and return metrics over time, providing a shock absorber for portfolios. It sounds simple.  

One of the issues that investors face is the blurring of what diversification means. Everyone will have seen presentations with lots of different assets and the presenter highlighting how diversified the portfolio is. Much of the time the diversification benefits are marginal, as the assets are still affected by the same market influences. The key is to understand and diversify the market risks that influence each asset.  

Adding assets that sound like they will add diversification, such as a bond fund, will not necessarily help. Not all bonds behave in the same way and they have different correlations, so you need to be careful with generalisations.  

On top of this, the interpretation of data is important. If you view two assets over a one-year period and they rise in value together (high correlation), you could misinterpret this as an indication that they have similar market drivers and risks. Yet it could just have been coincidental that they both rose in value that year. You should therefore also look at beta alongside correlation to have a better understanding of risk and correlations.  

The big issue for investors at present is that correlations and market influences change over time. For the past 30 years, equities and government bonds have had a negative correlation. It makes sense that they have a negative correlation, as equities generally fall in value in times of stress.  

The reaction of central banks and bond investors in times of stress has been to reduce interest rates or reduce the future expected level of interest rates, causing bond values to rise. The concern going forward is that the stress could be caused by rising interest rates.  

In that environment, both equities and bonds could fall in value. We did see a glimpse of this in May 2013 when Ben Bernanke, then chairman of the US Federal Reserve, suggested that the Fed would taper quantitative easing and look to raise interest rates.  

The result was that both equities and bonds fell. If you thought your portfolio was diversified because you had equities and bonds, you were nursing some losses greater than you thought possible because correlations changed.  

This is not new. Bonds have not always had a negative correlation to equities and there have been prior decades where correlations were positive, but investors have got used to the idea that pairing equities and bonds provides a balanced portfolio. If this is changing, investors need to rethink how they build portfolios. 

There are plenty of options out there being sold as alternatives to bonds to help investors diversify and balance portfolio risks. For some managers, allocations to fixed interest assets are now a third of what they were five years ago. Investment managers at Mattioli Woods have been going through a process of trying to identify assets that provide not just diversification benefits, but also higher expected returns than government bonds.  

I believe there is not a single asset or solution to the issue, but a change of approach and combination of assets that will help to achieve the goal of delivering genuine diversification and balance, while producing attractive returns.  

Some of that thinking is similar to that of the large US endowments in that alternative assets are going to play a larger role in asset allocation and can add some diversification benefits. Alternatives are generally classified by investors as anything other than traditional public equity and bond markets. 

As the understanding of alternative strategies improves, I expect they will become more mainstream over the next decade. At Mattioli Woods, some of our preferred assets are real assets, such as property and infrastructure, as well as absolute return strategies and commodities. 

Real assets – property and infrastructure

Investing in UK bricks and mortar can be an effective way of diversifying portfolio risk. Some advisers use closed-ended Reits to access UK commercial property and an equally weighted portfolio of UK Reits has very little correlation to UK or global equities over a three or five-year period.  

Capital values are sensitive to recessions though, so correlations do rise in times of severe economic stress. Mattioli Woods uses several Reits, including Custodian Reit, Picton Property Income and Standard Life Property Income Trust. We also like infrastructure as an asset class. There are different forms of infrastructure and we prefer social and economically critical infrastructure, where cash flows are generally from governments and demand is steady and incremental. Infrastructure has low correlations to other assets, which has made it a popular asset class in recent years. We use several infrastructure funds, including International Public Partnerships, John Laing Infrastructure and Lazard Global Listed Infrastructure Equity. 

Absolute return and hedge strategies

Mattioli Woods breaks this sector down into four styles, these being global macro, equity long/short, relative value and event. Historically, this sector has been seen as buying a solution, which partly might be due to the success of Standard Life’s Gars fund. 

However, we have always said with this sector, more than most, you need diversification within to ensure you have different drivers of risk and return to try to generate positive returns in different market conditions.  

The broader sector has proved that it can produce positive returns in different conditions, but it is reliant on manager and strategy selection. In this sector, we use funds such as Old Mutual Global Equity Absolute Return and Invesco Perpetual Global Targeted Returns. 

Commodities

This sector has had a tough few years, but due to the idiosyncratic nature of the sector, there are usually some commodities that perform well while others perform poorly. Despite this, commodities have different drivers to traditional equity and bonds, meaning they make excellent diversifiers.  

We currently hold gold in portfolios, which tends to perform well in times of stress. Other commodities, such as agricultural commodities, can also provide uncorrelated returns from traditional equity and bond markets.  

Other

Investment managers have seen how important currency can be to returns during the past year and having some US dollar denominated assets has provided important diversification in times of stress, both at the time of the EU vote last year and in the financial crisis in 2008.  

I also like areas such as private equity, which has some similar drivers to traditional equity, but can be more resilient in normal conditions and equity sectors including healthcare and insurance.

There is no perfect solution to the changing conditions in bonds, and to a lesser degree, equity markets. Bonds still have an important role to play in portfolio construction, but most areas of interest in bond markets are more equity-like and I consider them as growth assets. 

I expect that a balance of alternative assets, such as property, absolute return and commodities combined with equity, will help balance risk and return within portfolios. 

Ben Wattam is investment manager at Mattioli Woods

Key points

Diversification is when investors benefit from assets performing in different ways at different times.

Correlations and market influences change over time.

Investing in UK bricks and mortar can be an effective way of diversifying portfolio risk.