More Asset Classes = Better Diversification?
Given the current market environment, achieving the same level of risk-adjusted performance is becoming more challenging with the traditional 60:40 split.
As such, many investment managers now include a variety of asset classes in their portfolios. This may include real estate, private equity, commodities and so on.
The question then becomes: does this improve diversification? To answer this, it is important to consider the investors’ motivation behind a diversified portfolio.
Is it to maximise long-term returns at their risk level? Or to protect their portfolio against market downturns?
If it is the former, then it is true that a broader range of asset classes will expand the investable universe.
This offers additional sources of return/income and a greater chance of identifying undervalued assets.
Taking the example of real estate, some of the UK’s most popular property funds have annualised total returns in excess of 5 per cent over the last 10 years, and at the time of writing, offer 12 month yields above 3 per cent.
This is especially significant for investors seeking an income and considering that the current yield on the UK Investment Grade Bond Index is 2.5 per cent.
However, if the investors’ motivation is to protect against market downturns, it is important to consider how their portfolio will behave during different market conditions.
One of the few benefits of the financial crisis is that it provided a real-life stress test on portfolios that were presumed to be well-diversified. What we observed is that correlations tend to converge during periods of extreme market stress.
Continuing with the real estate example, for the US market, the correlation between real estate and the S&P 500 was just under +0.3 from 2000-2004.
However, between the end of 2007-end of 2009, this correlation rose to over +0.8.
This behaviour was even more pronounced when comparing the correlation of the S&P 500 to an index of US corporate bonds, which went from approximately -0.3 during 2000-2004 to over +0.3 between the end of 2007-end of 2009.
This is concerning because although the correlation of +0.3 is still fairly low, it does not offer the same downside protection as an asset that moves in the opposite direction.
Furthermore, commodities suffered large losses as the collapse in economic growth hurt demand and many private markets experienced liquidity crises.
What does good diversification look like?
The next obvious follow-up question is: what is considered a well-diversified portfolio? Again, we must consider the investors’ expectations and risk tolerance.
