Partner Content: Making the most of diversification in a multi-asset portfolio

One of these reasons doesn’t always get much attention, but has always played an important role in calculating optimal asset allocations. We’re calling it the ‘Risk Rebate’

There are a number of reasons why diversification through investing in multi-asset funds is a sound – and popular – strategy for investors.

One of these reasons doesn’t always get much attention, but has always played an important role in calculating optimal asset allocations. We’re calling it the ‘Risk Rebate’.

Diversification

Diversification is a fairly straightforward concept, and it’s relatively easy to grasp its main benefits. Many factors affect an investment’s performance, such as the health of the economy or industry, interest rates, investor sentiment and unexpected events (both positive and negative).

The impact of these factors may harm the performance of one asset type, but conversely improve the performance of another. That’s why asset classes tend to perform in different ways over different time periods.

By combining different types of assets in one fund, multi-asset managers seek to mitigate volatility and smooth out overall performance.

This is the well-rehearsed ‘eggs in more than one basket’ explanation, which remains the core rationale for diversifying investments – and something clients typically understand and like.

While the basic concept and core benefits are fairly simple, the design, implementation and management of an effective multi-asset portfolio can be complex. And perhaps the most challenging area of all is ultimately the most important: optimisation of the asset allocation.

Every portfolio has a certain amount of risk it can take on in order to meet its investment objectives. Measures of projected risk and return are quantifiable, and in a multi-asset portfolio, the total risk of the overall blend of assets is lower than the sum of the parts – and that is what we call the ‘Risk Rebate’.

This additional risk budget can be used to add exposure to higher-risk assets, resulting in the potential for better returns without exceeding the overall risk limits of the portfolio.

Optimisation and the risk rebate

Optimisation always strives to let investors have their cake and eat it, by creating asset allocations which could deliver the best possible performance without exceeding two ‘budgets’: the overall risk budget for the fund, and the fund’s charges.

Add in other potential constraints, such as where the fund can invest and what strategies are available, and we can see that optimising an asset mix is a delicate and intricate process.

This is where the experts who optimise multi-asset funds’ allocations can really add value. Through analysis and modelling, they can identify how to squeeze as much potential performance as possible out of an available array of assets without exceeding risk or pricing limits.

As market environments change, broader diversification plays a crucial role in planning and calculating any optimal blends of assets.

And one of the outcomes of effective asset allocation is the ‘Risk Rebate’, which allows them to increase exposure to growth assets without exceeding the fund’s overall risk budget.

The Risk Rebate can be illustrated by this example. XYZ Fund invested in three assets when it was first launched. Assets 1 and 2 are primarily growth assets and carry relatively high levels of risk.

It also invested in Asset 3, which is more defensive and carries less risk. If we add the 3 assets’ risk levels together, we see the ‘sum of the parts’ (ie, total gross risk). But because diversification reduces overall risk, we can stay within the stated risk profile for the fund.

Recently, XYZ Fund’s asset allocation team conducted a full optimisation review. They could not increase the overall risk budget, nor increase the charges to customers, but they could broaden and change the assets the fund invests in. They opted for a broader asset mix.

The Fund’s asset allocation team were able to take advantage of a much bigger Risk Rebate when planning and calculating the new optimal asset mix.

Because they knew they were broadening and improving the diversification, they could increase allocations to riskier assets and ultimately offer customers more exposure to growth assets without raising investment risk – which in turn could lead to better returns over the longer term.

Putting the risk rebate to work

This theory may sound straightforward, but putting it into practice requires significant expertise, analysis, and modelling capability.

Any additional asset classes need to be examined in isolation to determine their risk and reward characteristics, and then any proposed blends of assets must be rigorously tested and refined.

This process – and the resulting asset allocation – takes careful account of levels of correlation and how assets perform in different conditions.

Lastly, but vitally, any optimisation needs to take into account the cost of accessing each asset class, noting that some asset classes are more expensive than others.

Optimisation reviews and increasing diversification is increasingly important. As market environments change, broader diversification plays a crucial role in planning and calculating any optimal blends of assets.

It is founded on the simple logic that is at the heart of diversification, but in the hands of asset allocation experts, it is a key technique for increasing potential returns for your customers.  

For the latest insight, case studies and expert guidance on multi-asset investing, visit www.scottishwidows.co.uk/multi-asset

Iain McGowan is director, investments, for Scottish Widows