A modern approach to diversification

This article is part of
Guide to risk and return in multi-asset

A modern approach to diversification

Advisers have been using multi-asset funds and solutions as a way to diversify client portfolios for years.

By choosing a multi-asset fund, clients will have exposure to a range of asset classes more efficiently and cost-effectively than if they were to select several funds offering exposure to a single asset class.

Pre-financial crisis, diversification could be achieved primarily by constructing a portfolio of equities and fixed income.

But since the period 2008 to 2009, these two asset classes have become more highly correlated, proving something of a challenge for multi-asset fund managers. 

It also means advisers have to pay closer attention to the underlying assets in these products before recommending them to clients.

One way round this has been for multi-asset fund managers to adopt a more modern approach to diversification, which has seen the underlying assets in multi-asset funds change quite significantly over the past 10 years. 

According to Minesh Patel, director and chartered financial planner at EA Financial Solutions, who looked at some statistics from Deutsche Bank, in 1968 a multi-asset portfolio was essentially diversified across bonds and equities. 

“Whereas in 2018, multi-asset portfolios were diversified more broadly [across] alternatives, commodities, cash, fixed income and equities, which are further diversified within each asset class with reference to geography, size of equity holding, etc,” he points out.

“The investment framework has changed significantly in recent years under the weight of structural and cyclical forces,” observes Guilhem Savry, head of global macro and dynamic asset allocation, cross asset solutions at Unigestion.

“Indeed, the ageing of the world population and the decline in investment that followed the 2008 financial crisis led to a significant reduction in global growth potential.”

He continues: “Moreover, the increasing intervention of central banks, initiated to stabilise the financial system to deal with risks of deflation and to support growth, has generated a widespread decline in financial asset volatility. 

“In this context of declining growth potential and low yields, diversification can help to provide additional sources of lowly-correlated returns to achieve a smoother investment return profile through varying market conditions.”

True diversification

This presents advisers with a challenge; clients require more diversified portfolios than ever before, yet asset classes are becoming more highly correlated than at any other time and are delivering lower returns more generally.

So when selecting a multi-asset fund for clients, what exactly does true diversification look like?

Mr Patel says: “The best way to measure diversification is through the use of modern portfolio theory, and [by] considering the correlation of different assets in a multi-asset fund.” 

He notes that the less correlated the assets in a fund are, the more diversified the multi-asset fund is. 

“This is particularly important during periods of crisis, such as the financial crisis of 2008 to 2009, when assets become correlated,” he adds.