Oracle: What is the best way to diversify?

Oracle: What is the best way to diversify?

Multi-asset managers are currently sitting on large piles of cash in an attempt to limit downside risk and maintain diversification benefits in the face of rising valuations across practically all asset classes. Investors will be wondering whether this strategy has paid off. If not, where should multi-asset managers have sought diversification benefits?

To this end we constructed five portfolios to compare four different diversifiers; cash, gold, absolute return and global equities.

Our benchmark portfolio contains 60 per cent UK equities and 40 per cent UK bonds. To compare diversifiers, we have moved 10 per cent from UK bonds to one of cash, absolute return, global equities and finally gold, resulting in four additional “diversified” portfolios.

The benchmark portfolio has had a diversification benefit of 16 per cent in the five years to the end of 2017. Adding cash, absolute return or global equity caused the diversification benefit to drop to 14 per cent. This can be explained by the fact that absolute return and global equities are more closely correlated with UK equities than UK bonds. With a 10 per cent exposure to gold, diversification benefit rose to 22 per cent. On this basis alone then gold comes out on top as a diversifier.

However, in terms of overall risk as measured by volatility, gold is actually the worst addition with an annualised volatility of 7.46 per cent. So, diversification benefits did not translate in lower risk over the study period. The best portfolio in terms of both volatility and maximum drawdown is the portfolio with 10 per cent allocation to cash.

Although adding cash slightly reduces diversification benefit, it better protects against large drops in performance, highlighted by a low maximum loss. However, it also means that the investor would have missed out somewhat on the upside. While protecting on the downside, cash has acted as a drag to performance as most financial markets have trended to the upside over the last five years.

Reaction of five different multi-asset portfolios  
PortfolioVolatility (%)Maximum gain (%)Maximum loss (%)
UK equities, UK bonds6.8713.96-4.56
UK equities, UK bonds, cash6.6413.17-4.64
UK equities, UK bonds, global equities7.2915.18-5.33
UK equities, UK bonds, absolute return7.0313.44-5.08
UK equities, UK bonds, gold7.4615.78-5.4
Source: FE Analytics, 31/12/2012 to 31/12/2017  

The global equity portfolio significantly outperformed the others and diverged notably following the Brexit vote in June 2016. This can be explained by the depreciation of the pound which stayed weak for some time, raising the sterling value of overseas shares. In terms of risk-adjusted returns global equities was also the best addition to the portfolio.

In terms of performance then it seems that global equities have been the best addition for a UK investor. However, this can be explained by a large one-off shock. Unless you expect the pound to weaken 30 per cent again, global equities may not be the best choice of diversifier in future.

Moreover, if we start to observe greater divergence across asset classes after half a decade of seemingly coordinated bullishness in financial markets, then cash, as opposed to global equities, will start to garner more attention from managers looking to protect on the downside.

Charles Younes is research manager at FE