Creativity is the key to diversification

broaden exposure

We’ve all heard the old adage that diversification is the only free lunch. In other words, diversification is the only way to generate additional return for investors without taking on additional risk. Achieving diversification used to mean a portfolio of equities and fixed income, with greater proportions of one or the other based on an investor’s return objectives and risk tolerance. This simple diversification method worked well for decades, as both equities and bonds had solid returns.

But it isn’t so simple anymore.

Bond yields are extremely low in the U.S., and even more so in Europe. Therefore, diversifying out of equities into government bonds isn’t an attractive option. Our expected government bond returns range from 0%-2% compared to a long- term average of 6%-7%. This won’t even cover inflation in the long run; investors will barely break even at best. While long-term U.S. bonds might seem to be a better option, with expected returns around 3%, they aren’t a very good option in a rising rate environment. There is too much of a short-term risk of losing money due to falling bond prices, while over the long term, returns are expected to be much lower than they have historically been.

The story for equities isn’t much better. Equities are now looking reasonably expensive in terms of valuations, particularly in the U.S., where prices have risen substantially. While U.S. tax cuts may boost expectations in the short term, returns over the long term are expected to be much lower than they have recently been. On a 10-year horizon, we expect equity returns of 4%-5% rather than the 30-year average of 7%-8%.

Using these expectations, we estimate that a traditional balanced investment portfolio of equities and fixed income would be forecasted to deliver a return of around 3% versus an average of 7% over the last 20 years. For many investors, this won’t be enough to meet their objectives; they must instead seek out other differentiated sources of return. In other words, it’s time to get creative by diversifying into new regions, asset classes and market segments.

Looking further in fixed income

Emerging-market government bonds are a relatively attractive asset class, particularly the local-currency variety. While developed-market bond returns hover around 1%-4%, yields for their emerging-market counterparts average 6%. In many cases, emerging economies are in the midst of recovery, and prospects are good due to solid growth, controlled inflation and low levels of debt. Currencies are on average near fair value, meaning there is lower long-term currency risk. Emerging markets provide enhanced diversification within a portfolio invested in developed-market bonds because they respond differently to certain risks; for instance, they aren’t as impacted by rate decisions made by developed-market central banks.

Asset-backed securities (ABS) also look attractive when compared to conventional corporate credit. While they benefit from floating rates just as loans do, they also typically have wider spreads for the same level of credit quality. At the mezzanine level, spreads for BB-rated ABS are 2% higher than BB-rated high-yield bonds. Besides offering enhanced portfolio diversification, BB-rated ABS boast an attractive yield of 5% on average, reflecting compensation for the greater complexity and more limited liquidity in this sector.

Illiquid possibilities

For institutional investors able to invest in illiquid assets, private markets and real assets provide additional options. Real assets offer the opportunity to invest in a diverse range of cash-generating assets such as energy, mining, farmland and timberland. These assets are called “real” because unlike many “financial” equity and bond assets, cash flows arise from the ownership of a real physical asset, typically involving land. Returns tend to be positively correlated with inflation, making them good inflation hedges. At the same time, many real assets have a low or negative correlation with equities, which makes them attractive diversifiers. Timberland and farmland have performed especially well during economic recessions. At the same time, real assets tend to be long term and illiquid, with the likely investment time horizon being in excess of 10 years.

Private markets are another compelling consideration. Because the proportion of private companies to public has been steadily increasing, access to value creation and growth by way of the private markets has also expanded. This trend appears to be continuing as private companies held by private equity managers often stay private for longer. Scalable start-up technology companies require very little debt funding and can grow into very large companies. This has resulted in the rise of the unicorn, a company valued at $1 billion without the need to go public. Private markets typically offer higher returns than publicly traded assets because investors receive an illiquidity premium to compensate for losing the ability to withdraw their capital on short notice.

Being selective is essential

Investors can no longer rely on traditional asset classes alone for achieving their risk-adjusted return objectives. While diversifying into more specialized asset classes and market segments can help add diversification and return-generating opportunities, they may be more difficult to research and access. An experienced manager with a global view can provide technical expertise and an open-minded perspective, helping investors build a global, diversified portfolio that can withstand uncertainties and sudden downturns in the market.

The markets have changed. For now at least, returns for domestic equity and fixed income are no longer what they once were, and investors need to consider looking further afield in terms of both geography and asset class to achieve a properly diversified portfolio. Given dramatically lower return expectations, tried-and-true traditional asset classes will have less of a chance for success. Being creative will be the key to diversifying for the future.

Important Information

Foreign securities are more volatile, harder to price and less liquid than U.S. securities. They are subject to different accounting and regulatory standards, and political and economic risks. These risks are enhanced in emerging markets countries.

Diversification does not ensure a profit or protect against a loss in a declining market.

Among the risks presented by private equity investing are substantial commitment requirements, credit risk, lack of liquidity, fees associated with investing, lack of control over investments and or governance, investment risks, leverage and tax considerations. Private equity investments can also be affected by environmental conditions / events, political and economic developments, taxes and other government regulations.

Investments in asset backed and mortgage backed securities include additional risks that investors should be aware which include those associated with fixed income securities, as well as increased susceptibility to adverse economic developments.

Fixed income securities are subject to certain risks including, but not limited to: interest rate, credit, prepayment, and extension.

ID: US-120218-57459-1

The value of investments, and the income from them, can go down as well as up and you may get back less than the amount invested.

AAM Group