What is proper portfolio diversification?
As managers battle crowded trades and correlated asset classes, true diversification has become harder to achieve. Investment Week asks investors how they are tackling this issue.
Michael Spinks, co-portfolio manager, Investec Diversified Growth
Don't rely on labels
The starting point for genuine diversification is to focus on the underlying characteristics and behaviours of assets, rather than just relying on asset labels, to assess their roles in a portfolio.
In our view, a high yield bond behaves more like equities than a government bond and so should be regarded more like a substitute for equity, rather than a diversifier.
By understanding the expected behaviours of different assets and blending these characteristics accordingly, a portfolio can achieve superior structural diversification and more consistent outcomes.
In the current market, finding genuine diversifiers to equities is increasingly tricky. Developed market government bonds can still play a role, but managers now need to look beyond the traditional investment tool-kit, with active currency positions, option strategies, and relative value strategies all coming into play.
Eoin Murray, head of investment office, Hermes Investment Management
Proper portfolio diversification today involves a combination of beta-dominated assets to capture any upside and alternative strategies to offer some downside protection.
A level of flexibility is required to limit the effect of any potential liquidity disruptions (particularly in the corporate bond market), while not forgetting the responsibility that comes with being true fiduciaries.
Assets that offer genuine low correlation, particularly during periods of financial stress, should feature strongly. For that reason too, alternative strategies that provide low volatility will also be present, and mandates that offer greater flexibility will be favoured.
Dan Kemp, co-head of investment consulting and portfolio management, Morningstar
Confusion with correlations
Diversification is too often mistaken for historic correlation, as solving an equation is easier than thinking. Just because assets have not been correlated in the recent past does not mean they will continue to offer diversification benefits in the future.
A correlation-based approach can lead to investors overpaying for an attractive track record. This is especially true now where investors are using expensive government bonds to protect their portfolio against a fall in the price of equities.
Expensive assets tend to revert to fair value over the long term, so real diversification can only be achieved by including attractively valued assets that benefit from different drivers.
Portfolio managers need a realistic view of future returns and an approach that covers a range of conventional and alternative assets.
Brendan Walsh, multi-asset fund manager, Aviva Investors
Move to multi-strategy
Over the past 20 years, portfolio diversification has been an exercise in selecting the ratio between bonds and equities.
This was typified by the diversified growth fund or balanced fund approach, which performed well up until 2008 when most DGF funds fell 30%. Their ability to achieve diversification was driven by the long bond bull market.
However, with yields now close to zero and negative, on a prospective basis this approach will not only fail to be properly diversified, it will also likely struggle to achieve growth consistent with long-term equity risk premium.
The solution is to increase the number of independent return drivers by moving from multi-asset to multi-strategy, focusing on macro ideas rather than asset allocation and analysing how these ideas interact under historic and future scenarios.
Florence Barjou, head of multi-asset, Lyxor Asset Management
In current markets, where most asset classes are trading at expensive valuations, diversification should be viewed as a necessary, but not sufficient step for absolute performance.
Combining uncorrelated sources of returns, typically also by expanding the investment universe, remains a robust way of generating a given level of income, but with less risk.
However, when times are uncertain, the trading environment can change brutally, and correlations can shift rapidly. In such a context, even a well-diversified allocation, if it is managed with a 'buy and hold' spirit, can post losses.
Current markets require not only tactical reactivity, meaning the ability to rapidly shift from one asset class to another in an unconstrained way, but also the capability to control and cap risks at the overall portfolio level.
Investors should thus move away from the strategic, static mix of the past, and favour a dynamic diversification process within a well-controlled risk framework.
Mike Pinggera, fund manager, Multi-Strategy fund, Sanlam FOUR
The basic premise of diversification is simple; by investing in a range of different investments with different characteristics the overall risk/return of a portfolio can be improved. All you need to do is calculate or forecast the expected returns, volatility, and correlation.
Unfortunately, assets rarely behave the way they are forecast to, and indeed, in a world where unconventional policies dominate, the unexpected should be expected.
For many years now, I have favoured an approach based on discipline and liquidity, rather than construction based on forecasts. At present, we have exposures to equity, infrastructure, mid-cap and emerging market relative trades, government bonds, volatility and commodities.
However, risk is managed through a process that relies on discipline and liquidity. Discipline involves setting clear downside risk tolerances or active 'stop losses' for each investment. Liquidity ensures that losses can be stopped when required.
Yves Choueifaty, president and founder, TOBAM
No sector bias
Portfolio diversification is not dependent on the market environment. The way to obtain a properly diversified portfolio is to use diversification as the only criteria for investing.
Being diversified means a portfolio has no bias towards a particular sector, stock, style or source of risk and this can be achieved only if diversification is central to the construction process.
Our maximum diversification approach relies on maximising a patented proprietary measure of diversification. It creates a portfolio that equally allocates to all of the sources of risk. It allocates to the most diversifying stocks and is more correlated with the stocks it excludes than with any of the stocks it holds.
The most diversified portfolio delivers the risk premium from all the effective independent sources of risk available in the market at any given time. This approach reflects the conviction that if markets are difficult to forecast, diversification should be core.
Adam Ryan, manager, BlackRock Income Strategies trust
Broad asset spread
Prospects for interest rate hikes, election uncertainty. a strong dollar, and weak oil prices have led to an increase in market volatility. By dynamically investing across different asset classes, multi-asset income funds can give investors a smoother ride than less flexible portfolios.
This is thanks to a broad spread of investments that seek to capture opportunities and real growth in income, but with an eye to capital preservation. This might mean exposure to European equities yielding 4%, UK commercial property yielding 5%, or Brazilian inflation-linked bonds yielding 6% per year.
The lack of a benchmark means multi-asset portfolios can also hold more defensive positions when required. We can use derivatives strategies to hedge exposure and cash to preserve capital and prepare for growth opportunities in the future.
The trust does not have to own an
asset class that is not attractive - for example UK gilts, which are expensive and do not compensate for potential volatility in the near future.
Paul Jackson, head of research, Source
Spread the risk
The traditional meaning of diversification is to spread your investments to limit exposure to idiosyncratic risk.
However, in a world of high correlation, it has become increasingly difficult to achieve diversification. Investing in broad indices is a way to avoid a lot of specific risk but we can go further.
Spreading investments across a range of assets is a good starting point – equity markets are highly correlated with one another, as are fixed income markets, but the correlation between equities and bonds is low (and frequently negative).
Second, within the equity and debt categories, emerging market returns are de-correlated with those of developed markets and offer good diversification.
Within developed equity markets, Japan tends to have a low correlation with the rest, thus offering diversification. Gold has some desirable characteristics, but behaves like safe-haven bonds in times of crisis and like equities when inflation is on the horizon.
Mark Rimmer, multi-asset product director, Premier Asset Management
Mix up the ingredients
With both equity and bond markets currently at very elevated levels, in part due to various rounds of quantitative easing throughout the world but also as the global economy has recovered from the credit crisis, the importance of diversification could not be greater.
Uncertainty abounds, highlighting the importance of diversification and the need to construct a portfolio that can survive a range of different outcomes.
We believe a well-diversified portfolio of good quality assets that are attractively priced will provide investors with the optimal outcome over the long term.
For our multi-asset portfolios, we diversify by asset class, fund manager, and fund structure to ensure investors are not overly reliant on a single type of investment.
One of the keys to successful multi-asset investing is mixing the ingredients in the right proportions and changing the mixture at the right time.
Steven Andrew, manager, M&G Episode Income fund
Manage assets dynamically
With the yield of traditional sources of income at rock bottom, investors have to diversify to alternative assets to generate returns. However, genuine diversification means more than holding a certain amount of alternative asset classes in a portfolio.
History has shown us that no asset can be relied upon to behave in a consistent way under every market environment. This is the case either in terms of individual assets risk/return characteristics, or in terms of how assets behave in relation to each other.
Therefore, simply holding a static mix of assets may result in investors exposing themselves to greater risk and missing out on opportunities to maximise returns.
The answer is to manage a portfolio of assets dynamically by continually monitoring and rebalancing allocations. This can help fulfil the ultimate aim of being invested in the right assets, at the right time.
Malcolm Jones, investment director, absolute returns & multi-asset investing, Standard Life Investments
While bond markets still offer diversification, the opportunities for making money are much reduced after many years of declining bond yields.
However, in a world of divergent monetary and fiscal policies there are still profitable opportunities such as Australian short-dated interest rates that also offer good diversification.
Increasingly, gaining both a return on your investment as well as owning something that offers significant diversification to traditional growth assets can be found in the currency markets, as well as relative value opportunities in the world's major equity and bond markets.
For example, being long the dollar versus the Canadian dollar and euro has been both very profitable in recent times, as well as having strong diversification potential in a balanced multi-asset portfolio.
In addition, selective investment opportunities also exist in the volatility markets that can offer significant protection to a portfolio in periods of increased market stress.
Alastair George, 8AM Global
Portfolios should include cash
Furthermore, we question whether so-called alternative assets will ultimately prove to be uncorrelated if liquidity is drained from markets.In terms of portfolio diversification, lies, damned lies and statistics are the close relations of forecast returns, correlation and mean-variance optimisation. At present, it may be better to own theoretically sub-optimal portfolios which are in practice more robust.
Diversification strategies must recognise that expected returns across asset classes have been systematically depressed by ultra-loose global monetary policy. With this dominant common factor driving returns, correlations across asset classes have also increased, making true diversification much harder to achieve.
With the traditional diversifier of government bonds losing appeal with rates so low in real terms, in our view proper diversification now has to include a higher allocation to cash or cash equivalent investments; value has to be found by being prepared to invest across asset classes and geographies and if possible investors should also consider allocating to market-neutral arbitrage strategies to enhance portfolio returns.
Eugene Philalithis, co-manager, Fidelity multi-asset income fund
Spread the risk
For me, real portfolio diversification is about spreading risk intelligently across asset classes. In the funds I manage, I focus on achieving a stable and sustainable level of income for investors over time. In this sense, ‘proper' diversification is about diversifying income streams as well as sources of return, combining asset classes deliberately to generate consistent yields from a portfolio throughout a market cycle: not simply throwing lots of different asset classes together and waiting to see what happens.
In the current market environment, a smart approach to diversification is particularly important. With yields on traditional income-generating assets still at record lows, investors are being pushed further along the risk spectrum when looking for income. In the funds I manage, we can hold more opportunistic asset classes such as loans, infrastructure and emerging market debt (EMD), as well as traditional building blocks like equities and bonds. At the moment, I see the best prospects for income in growth-orientated assets like infrastructure, but a truly diversified portfolio looks longer-term in its asset allocation, and while I'm underweight traditional income asset classes such as government and investment grade bonds at the moment, they're still part of the portfolio.
Yves Choueifaty, president and founder of TOBAM
Portfolio diversification is not be dependent on the market environment. The way to obtain a properly diversified portfolio is to use diversification as the only criteria for investing. Being diversified means a portfolio has no bias towards a particular sector, stock, style or source of risk and this can be achieved only if diversification is central to the construction process. Our maximum diversification® approach relies on maximizing a patented proprietary measure of diversification. It creates a portfolio that equally allocates to all of the sources of risk. It allocates to the most diversifying stocks and is more correlated with the stocks it excludes than with any of the stocks it holds. The most diversified portfolio delivers the risk premium from all the effective independent sources of risk available in the market at any given time. This approach reflects the conviction that if markets are difficult to forecast, diversification should be core.