Why is portfolio diversification complicated?
The universe of assets that can provide a low or negative correlation to equities is vast. However, for many years, investors relied heavily upon government bonds to provide ballast to portfolios dominated by stocks. This proved effective, stock market wobbles were typically triggered by demand shocks – a few well-known examples include the early 2000s dotcom bust, the global financial crisis in 2008, and the global growth scare in 2015. Demand shocks are associated with low inflation, so bonds perform well as investors factor in expectations of lower interest rates.
Bonds did their job well until post pandemic inflation pressures led to a rate reset in 2022. This reminded investors that government bonds are not always reliable. As uncertainty, protectionism and fiscal spending are now features of the economic and investing landscape, the importance of considering a wider set of diversifying assets has been reinforced.
What are the options?
There are many options to choose from, and some are considered below. Unfortunately, none are without drawbacks, so we need to be selective and mindful of when we allocate to each.
As noted above, bonds tend to perform well when there is a negative shock to demand. They also have the advantage of being highly liquid. The drawback comes in inflationary environments when the fixed income offered from bonds reduces in value in real terms, thus making bonds unattractive. Even inflation-linked bonds fell in 2022 as the inflation sensitivity wasn’t enough to offset the vulnerability to higher interest rates. It’s a large universe though and, if we dig deeper, we can find areas of the market that are not interest rate sensitive, such as asset backed securities, or can benefit from safe-haven currency demand, such as short-dated US bonds with the US dollar being the dominant global reserve currency.
Over the long-term, gold exhibits a low correlation to equities and bonds and has historically proved itself as a safe-haven asset during both growth and inflation shocks. As a supply constrained asset, it can offer inflation-protection in a world in which the money supply keeps rising and geopolitical risk is elevated – as we have observed over recent years. Gold can also be accessed cheaply via exchange-traded products. Broad commodities (and oil specifically) also offer diversification and can produce strong returns, particularly during geopolitical events such as the current conflict between the US, Israel, and Iran. However, gold and other commodities do not pay a dividend or a coupon, a clear drawback for investors that value an income stream.
Private markets offer access to return drivers unavailable in public markets and can demonstrate a low correlation with public assets. While diversification of returns is attractive, private market investments do not offer crisis protection. Reported valuations tend to move slowly and can appear to smooth the path of portfolio returns in a downturn. However, economic sensitivity still exists, and valuations may just lag reality. Private market investments are also illiquid and come with high fees.
Absolute return or hedge funds seek to deliver returns in all markets so can be ideal for diversification purposes. For an asset allocator this means outsourcing alpha generation. This comes with risks as there are huge variations between outcomes across the universe; much deliberation is required in the selection process.
Finally, there are quantitative trading strategies that have been commonly used within sophisticated funds at asset managers for years to diversify risk but haven’t been available to wealth managers – typically due to the use of complex derivatives or knowledge gaps. For example, strategies that directly benefit when market volatility rises. Some investment houses have started packaging up these strategies into fund structures to bridge the access gap. A key difference between users is that sophisticated funds can often use leverage to deploy complex strategies whereas, for most wealth managers, cash constraints mean that opportunity costs are a consideration, so an in-depth understanding is needed to compare with other options.
Managing the volatility of returns in the current environment
In an environment characterised by fragile geopolitical relationships and huge government debt piles, portfolio diversification needs to be reconsidered. Nothing is without drawbacks, however, so careful selection is critical and a blend of approaches may be optimal.
