InvestmentsJul 9 2020

Diversification in a multi-asset portfolio

Supported by
Rathbones
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Supported by
Rathbones
Diversification in a multi-asset portfolio

Asset allocation was once a straightforward process for multi-asset investors.

The prevailing economic and market conditions determined the proportion of bonds and equities held within a clients portfolio, and more often than not that equated to a 60/40 split between stocks and fixed income.

The theory underpinning this is that government bond and equity prices move in opposite directions to one other, such that in times of buoyant markets, equities perform well, and in tougher times, government bonds do well as investors rush for safety.

But the decade since the financial crisis has seen government bond prices rise steeply, while equity markets have also risen sharply in value, presenting challenges for those adhering to established asset allocation methods.

One test of the durability of portfolios came with the pandemic-prompted market meltdown in March. On that occasion, “government bonds did the traditional job expected of them”, according to Keith Balmer, multi-asset fund manager at BMO.

He says: “The challenge with trying to build a diversified portfolio is that at times of severe market stress, all correlations among all asset classes go to one.

The best equity diversifier is to find a fund manager who can consistently outperform relative to the wider market.--Phil Smeaton

"But in March, after an initial wobble, government bonds did their job and performed well. There have been many pretenders to the crown in terms of being a diversifier, but nothing has performed as well as that this year.”

Exposure to dollar assets

The UK 10-year government bond yield has fallen from 0.8 per cent to 0.2 per cent in 2020, and as the yield falls when the price rises, this represents an capital gain for investors. 

Mr Balmer says the other way he tends to diversify is by taking exposure to investments in a wide range of markets, rather than being overly exposed to the UK.

He adds that having exposure to US dollar assets is also a crucial part of building a diversified portfolio, as the dollar tends to perform well in times of uncertainty, as occurred in March.   

The dollar tends to perform well when uncertainty is at its height partly because US companies and individuals bring cash they had invested overseas back to the US, and convert it into dollars to help them ride out the storm.

The second reason the dollar performs as a safe haven is investors around the world buy US government debt, believing it to be uncorrelated to equity markets.   

Mark Jackson, product specialist on the multi-asset team at JP Morgan Asset Management, notes that the US 10-year government bond yield from almost two per cent at the start of the year to as low as 0.3 per cent in March as investors moved in.

Building diversification

We find that by dividing assets by characteristics, rather than asset class, we are better able to control and manage risk.--Craig Brown

He says: “The US government bond offers investors protection. Now, with the price having risen so much, the cost of that protection is higher. But government bonds are not really assets you own for a return, they are there for protection.” 

Peter Fitzgerald, multi-asset investor Aviva Investors, says “government bonds categorically have a role to play” in a diversified portfolio. 

In terms of building diversification into the equity allocation of a portfolio, Phil Smeaton, chief investment officer at wealth manager Sanlam, adds: “The best equity diversifier is to find a fund manager who can consistently outperform relative to the wider market.

"When you invest in equities, you always get beta, which is the return the market produces, such as one can get from a tracker fund. Alpha is the additional return produced by a fund manager, and as there are relatively few active managers out there who can produce returns greater than the market on a consistent basis, alpha is hard to find.

"I think long/short funds {funds where the manager can both short sell stocks and also invest in shares to go up in value} are a good way to get alpha and also to get diversification, because the short selling part of the portfolio can go up when wider markets are falling.”

Craig Brown, investment specialist on the multi-asset team at Rathbones, says his approach is to invest directly in equities, rather than buy equity funds, as this increases the precision to invest in the parts of the market that the team likes. It also means, he says, the team are accountable to  investors for each stock bought.

Diversification means different things in a world where you have deflation rather than inflation.--Clark Fenton

He says the team uses “volatility to our advantage”, meaning buying more of the shares that have fallen from favour, and building a portfolio that is not exposed to only one risk.  

They add broader portfolio diversification by dividing all asset classes into three groups: assets held for liquidity reasons, assets held that have the same risk profile as equities, and assets which are deemed diversifiers. 

Mr Brown says: “We find that by dividing assets by characteristics, rather than asset class, we are better able to control and manage risk.

"By focusing on how assets behave and correlate with equities during market stress, it helps ensure that we do not fall into the trap of some more traditional asset allocation frameworks where fixed income, for example, is all treated similarly from a risk perspective.”

Looking ahead, those constructing portfolios face other macroeconomic decisions that will define their allocations, according to Clark Fenton, portfolio manager at RWC Partners.

He says: “Diversification means different things in a world where you have deflation rather than inflation. Traditional diversifiers work most of the time, but for a period in March they didn’t.

"One of the ways we manage diversification is by [taking exposure to] the Vix volatility index, which is a way of investing in volatility in the market, so the investment goes up in value when volatility is rising, and down in value when volatility in the wider market is falling.”

Time horizons are also crucial. Fahad Kamal, senior market strategist at Kleinwort Hambros, says bluntly that an investor with a decades-long time horizon need only invest in equities, but a shorter time frame than that, requires the use of cash and bonds to manage volatility.