Investment management 101 tells us diversification is needed to achieve the best risk-adjusted return over the long run, writes Emma Saunders, research analyst at Rathbone Investment Management.
In the recent bout of turbulence, it was easier to see the benefits of having assets that do not track equities closely than when everything is going up.
But what makes sensible diversification? How can you avoid diversification becoming 'diworsification'? Do diversification characteristics change depending on market conditions?
In order to construct portfolios effectively and manage risk, we divide assets into three building blocks, which play different roles - liquidity (mostly safe-haven government bonds and cash), equity-type (such as shares, corporate bonds and emerging market debt) and diversifiers.
This third category comprises assets that demonstrate a low or negative correlation to equities, particularly during periods of market stress. They include precious metals, non-directional alternative strategies, targeted return strategies and unleveraged commercial property.
Although these assets tend to exhibit diversifying characteristics across a range of environments over the long term, the performance of the different types of strategies can vary significantly over shorter periods. From a tactical perspective, it can be helpful to consider which diversifiers are most suited to the current investment climate.
Actively managed strategies
We believe the environment for some strategies has become less favourable. For example, returns within equity markets have become less dispersed, M&A activity remains subdued and common factors (such as value and growth) are starting to drive the return of a wider spread of equity-type assets.
However, we continue to believe overweighting these assets is still important for generating attractive risk-adjusted returns in a balanced portfolio. Although over the past three years our diversifiers have not beaten US equities, they are not supposed to. Indeed, we would be highly concerned if they had.
Instead, most of the strategies we invest in have delivered steady, small, uncorrelated returns, which is what we would expect from assets that are meant to provide a form of protection against periods of market stress.
The correlation between equities and many of our diversifying assets remained low or even negative during the difficult markets in the first half of the year.
This is likely to be more important than ever over the next year or two, when markets are likely to suffer recurring bouts of volatility, driven by rising bond yields.
From a strategic asset allocation perspective, we highlight the importance of holding a wide range of diversifiers to vary risk exposures. However, from a tactical perspective, it can be helpful to consider which diversifying strategies are most suited to the current investment climate.
Broadly speaking, our hedge fund indicators are signalling anaemic stock dispersion and subdued M&A activity, but markets are becoming more directional in nature, which was not the case last quarter.