Diversification will 'work once again'

Diversification will 'work once again'

Diversification in portfolios will become more attractive as uncertainty in global markets saw a wide range of assets struggle, an expert has said.

The rise in interest rates in the past year has led to a reduction in liquidity in all asset classes as they are “inherently overbought,” said Torsten von Bartenwerffer, co-head of multi-asset solutions at Fisch Asset Management.

“What we saw in recent months was a 'liquidation trade' of multi-asset portfolios, but they are now back in a strong position…diversification is starting to work once again.”

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Higher interest rates mean higher returns, which means a greater potential for diversifying safe haven investments, as interest rates have the potential to fall again during times of crisis, he added.

“Ultimately, the current market phase of high inflation and rising interest rates will come to an end, giving way to a period of still high, yet slowly declining, inflation.

“This means that the sectors that have suffered most over the last two years could be the winners of tomorrow.”

One of these sectors is bonds, and indeed investors seem to be pivoting back into the assets with UK bond funds seeing inflows of £1bn in August this year, as they fled equity funds.

One area that could give an advantage to investors are convertible bonds, von Bartenwerffer said.

These instruments are bonds that can be converted into a predetermined number of shares, normally at the discretion of the bondholder.

Convertible bonds are attractive as a lot of innovative small and mid-cap companies offer them, he said.

“Valuations for such companies have fallen considerably over the last two years which means that convertible bonds not only offer absolute upside potential, but also offer the potential to generate relative upside compared to equities. 

The chart below shows that convertible bonds are relatively cheap compared to equities, based on past returns.

12-month equity returns minus 12-month convertible bond returns 

Source Bloomberg, Refinitiv  

Ultimately, three components are needed to ensure a successful multi-asset approach, according to von Bartenwerffer.

“Firstly, a stable strategic asset allocation that guarantees the basis for harvesting risk premiums in the long term as part of a well-balanced portfolio.”

Secondly, he added, active management that navigates future inflation and economic cycles successfully. 

“Thirdly, the inclusion of convexity into the portfolio structure, as investors will have to deal with more frequent market turbulence and crises in the post pandemic era.”

Convexity is a measure of how steeply the relationship between bond prices and bond yields. If the duration of a bond increases as yields increase, the bond is said to have negative convexity.

“Thus,” von Bartenwerffer said, “a backdrop of persistent uncertainty and a combination of higher interest rates  and bond yields, with inflation set to fall again in the medium term, is creating an  environment in which diversification should pay off.”

“Multi-asset funds have become more attractive again.”