Also, modest allocations to more niche assets could be considered, for example funds offering exposure to direct infrastructure, particularly in areas important to the modern economy such as data centres, specialist property funds focused on secure income streams with strong asset backing or even newer assets such as carbon credits.
Currency exposure also plays a useful part in a diversified portfolio. Sterling tends to be a pro-cyclical currency, which as we have seen can also be subject to political risks, so allocations to the US Dollar and Japanese Yen can offer protection to sterling based investors in difficult periods.
Sterling being pro-cyclical means it tends to rise when the wider economic climate is positive, and fall when it is negative.
Of course, the US can also be the source of political risks, but in contrast to other currencies, the US dollar often rises when the US is the source of political risk, as investors seek a haven in the global reserve currency. Consequently, in the absence of a strong currency view, holding US or Japanese equities on an unhedged basis should probably be the default for most sterling-based investors.
The dollar is therefore another example of an asset that rises in value when equities are potentially falling sharply.
Finally, from an asset allocation perspective, there is a tactical argument for holding a higher-than-usual cash weighting. Although elevated cash weightings are a drag on portfolio returns over the long term, they can be useful over the short term, especially following a period of strong equity returns and uncertainty over inflation and interest rates.
Diversification within asset classes
How a portfolio obtains its exposure to an asset class can also offer an important source of diversification, particularly in equities, where historical style and factor behaviours are fairly well defined. Within equities, value styles may offer protection against higher inflation and interest rate regimes, and can be implemented either actively or passively across sectors, to help avoid excessive weightings in the ‘typical’ value areas such as energy and financials.
Value strategies usually require economic growth to remain on track. However, strategic asset allocations will inevitably encounter cyclical downturns, hence balancing other factor exposures is important. While some high-growth areas carry valuation risk at present, we have seen that more established and profitable growth businesses with strong balance sheets can also offer defensive characteristics, given their essential role in modern societies. Hence an allocation to quality growth can help diversify and balance equity exposures.
