Multi-assetMar 28 2019

A modern approach to diversification

Supported by
Rathbones
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Supported by
Rathbones
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.

You have to look beyond the traditional high-level asset class splits in portfolios to provide real diversification and manage riskDavid Coombs

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. 

For David Coombs, fund manager of the Rathbone Multi-Asset Portfolio Funds, it means: “You have to look beyond the traditional high-level asset class splits in portfolios to provide real diversification and manage risk – ie not all fixed income was created equal when it comes to performance during tougher economic times. 

“We classify assets by evaluating how liquid we expect them to be and the expected correlation to equities during stressed market environments.”

Mr Coombs cautions: “It’s of little use trying to balance equity risk with credit and high yield, which are likely to be less liquid and correlated to equities during stressed markets. 

“Nor, in our view, is it useful to point to property funds as a sensible risk offset to equities, given the pro-cyclical nature of the asset class, and the quite clear issue of liquidity in stressed markets.”

Mr Savry explains diversification means two things to Unigestion.

“Firstly, as we believe that the macro environment drives asset performance over the long-term, it is critical for a strategic allocation to include different assets that each provide their own value-add during different parts of the economic cycle. 

“We call this 'diversification across macroeconomic regimes',” he says. 

“Secondly, we recognise that expected returns for traditional assets is low and lower than in the past, hence we need to expand the universe of risk premia by including liquid alternative risk premia in order to realise the benefits of diversification. We call this 'diversification across risk premia'.”

Diversification or correlation?

One common mistake is to assume that as long as the assets in a multi-asset fund are delivering positive returns, and heading in an upward trajectory, the fund or portfolio is diversified.

Mr Coombs points out: “If your entire portfolio is heading in the same direction at the same time, even if that direction is higher, this is not diversification, it is correlation, and should lead to investors asking questions about how effectively risk is being managed.”

When it works, a truly diversified fund should be able to protect investors from the worst stock market falls, on the basis that if equities are suffering from a period of poor performance, other assets in the fund will be performing well.

Mr Coombs says this approach to diversification certainly helped his funds during the fourth quarter of 2018, particularly in December. 

“Our portfolios all managed to protect against the worst of the falls in equities, with each of them outperforming expected outcomes, given their respective risk budgets,” he recalls.

But it is important advisers and their clients do not simply assume that the more varied the asset classes held in a fund, then the more highly diversified it is.

Ben Seager-Scott, chief investment strategist at Tilney Group, says: “I think the key to diversification isn’t necessarily having ever more asset classes and different instruments, but rather trying to use offsetting factors to maximise the efficiency of your investment.”

He acknowledges that, traditionally, this has been through asset classes such as equities and fixed income, but he points out there are now a range of other strategies that multi-asset portfolios can employ. 

He continues: “It is important to understand the risk characteristics of different asset classes and strategies, ensuring that diversification changes actually have a meaningful impact on improving portfolio efficiency.”

Safe haven assets

This does not have to be at the expense of more traditional asset classes though, which still have their role to play, as Mr Coombs points out.

“Our approach to risk management can sometimes still lead us to a more ‘traditional’ looking asset allocation,” he notes. 

“For example, our portfolios currently look quite traditional as we have been adding to sovereign bonds, put options, and gold for ‘safe haven’ exposure. Factors such as the rapid progress in technology and artificial intelligence pose deflationary threats across the globe and sovereign bonds remain an effective way to combat this.”

eleanor.duncan@ft.com