Deeper diversification: Change your perspective

broaden exposure

Many astute investors have long recognized that diversification is an essential part of investing for the long term, and many may already believe they have achieved an adequate level of diversification within their portfolios even if they may lack certain specialized asset classes. After all, when looking at the correlation of individual U.S. stocks to each other, as shown in Chart 1, U.S. equity market correlations have fallen to their lowest levels in more than a decade.

In addition, traditional balanced portfolios of 60% stock and 40% bonds haven’t experienced a drawdown (or decline in market value) of more than 10% since the global financial crisis (Chart 2). It’s no wonder many investors have become comfortable with their current level of diversification.

Chart 1: Correlation of stocks in S&P 500 Index to each other

Source: Bloomberg, Standard Life Investments, February 2018.

Chart 2:

Source: Aberdeen Standard Investments calculations based on data from Robert Shiller (www.econ.yale.edu/~shiller/data) as of December 31, 2017.

The danger is that they fail to see beyond the here and now to measure and assess potential future risks, and then decide how to address them. This is understandable, as it can be difficult to determine risk exposures and decide whether or not a portfolio is properly diversified.

But if they take a close look, investors will realize that it’s vital to face these challenges and make thoughtful decisions regarding long-term asset allocation strategies. Recent market volatility serves as a reminder that the calm market environment we’re used to may not last forever.

It is vital that investors face these challenges and make thoughtful decisions regarding their long-term investments.

All around us, the world is changing. Emerging markets are gaining a larger portion of the world’s wealth and market capitalization, while developed markets have recently faced more uncertainty as they grapple with changing political landscapes and central banks’ plans to eventually unwind the accommodative monetary policies that have been in place for nearly a decade.

At the same time, new asset classes and market segments are being introduced, with some having the potential to enhance portfolio diversification and lower total portfolio risk. In order to adapt to these changes, investors need to take a fresh look at deepening their portfolio diversification.

Not only must investors reexamine their current allocations, but they must also challenge their ingrained notions of what it means to be diversified. In this paper, we will look at traditional and new ways to measure risk in portfolios, as well as where investors should look for new opportunities to improve portfolio diversification going forward.

It is an exciting time to be investing, and investors that fully take advantage of all that markets have to offer should find themselves better prepared for the many turns the markets can take.

The limitations of the “60/40” portfolio

For decades, many investors felt that a “balanced” portfolio, which traditionally consisted of a standard allocation to approximately 60% domestic stocks and 40% domestic bonds, delivered adequate diversification and compelling risk-adjusted returns. And this seemed true for a number of years as investors benefited from double-digit bond yields and stock market returns. However, when looking at a proxy for this portfolio consisting of 60% S&P 500 Index and 40% Bloomberg Barclays U.S. Aggregate Bond Index, it is clear that return expectations for this type of portfolio have changed dramatically.

The S&P 500 Index returned 18.2% on average during the 1980s and 19.0% on average in the 1990s; expected three-year returns for U.S. equities are now projected to be around 4.4%, according to Aberdeen Standard Investments’ long-term outlook. Likewise, the Bloomberg Barclays U.S. Aggregate Bond Index returned 12.8% on average during the 1980s and 7.9% on average in the 1990s, but Aberdeen Standard Investments now expects that three-year returns for U.S. investment-grade bonds will be around 2.3%. Expectations for bond returns are more problematic than those of stock returns since all three components of U.S. yields are well below their pre-crisis levels.

For many investors, the traditional approach of allocating to only a small number of asset classes in an environment with low expected returns won’t be enough to help them achieve their return objectives. Investors searching for true diversification among their investments will need to venture out beyond the 60/40 portfolio of traditional assets to find investments that not only have greater return potential but can also respond to changing market conditions, including periods when equity markets experience a downturn.

Investors searching for true diversification among their investments will need to venture out beyond the 60/40 portfolio of traditional assets

Problems with looking backwards

Measuring portfolio diversification relies on measuring the sources of risk in the portfolio. Many investors emphasize correlation during their evaluation, believing that if the correlation of the investments in the portfolio to one another is low, this implies greater diversification. But putting too much emphasis on correlation can also be misleading.

Here are three examples that show why looking only at asset class correlations is insufficient for assessing whether or not a portfolio is truly diversified:

  • Tail behavior.Tail behavior refers to how two markets behave during an extreme (or tail) time period or event.One tail-dependent relationship that correlation fails to capture is that between equities and investment grade corporate bonds. During times of market stress and volatility, these two asset classes tend to move in close alignment. But over the last 10 years, the correlation between stocks (represented by the S&P 500 Index) and corporate bonds (represented by the Bloomberg Barclays U.S. Corporate Fixed Income Index) has averaged just -0.17 using one-year intervals and a weekly time window. Only a slight increase in correlation could be seen even during the most turbulent months of the global financial crisis. While these two asset classes had similar performance patterns, correlation failed to capture this connection.

  • Regime shifts. As the Eurozone dealt with its debt crisis over the past 10 years, correlations between the euro and U.S. dollar fluctuated dramatically, as shown in Chart 3 below. For instance, when looking at one-year rolling periods, correlation swung between a low of -0.63 in May 2010 (marking the worst of the Eurozone crisis) and a peak of 0.59 in February 2015 (coinciding with quantitative easing). In both cases, there were unique, persistent market drivers influencing correlation over the timeframe.

  • Outlier events. Investors seek consistent and practical methods to evaluate correlations between their portfolio exposures. However, the degree to which an individual historical event may destabilize correlation figures can be surprising. Chart 3 shows the impact of Switzerland’s abrupt and chaotic removal of its three-year-old currency linkage with the euro in January 2015. This rocked the financial markets, with the Swiss franc soaring over 20% versus other currencies, while Swiss equities plummeted. This had a very dramatic effect on correlations.

Chart 3: Historic correlation of USD/EUR currencies with European equities

  Source: Bloomberg as of June 30, 2017.

While useful, typical backward-looking measures such as correlation can’t provide a comprehensive view of portfolio risk. As previously mentioned, this was certainly the case during an extreme event like the global financial crisis. Investors focusing solely on historical information in isolation from other factors will miss the bigger picture. Instead, they need to consider other methods that are complementary to examining correlations in order to arrive at a more nuanced analysis of their portfolios. Forward-looking measures can help provide a more holistic view of portfolio risk.

While useful, typical backward-looking measures such as correlation can’t provide a comprehensive view of portfolio risk.

Looking ahead

Using forward-looking techniques such as scenario analysis helps assess a portfolio’s behavior under unforeseen capital market events. While there are a variety of methods available, investors must consider what would work best for their particular portfolio.

For example, adding or subtracting 100 basis points (bps) to bond yields to determine what return outcomes might be expected for the whole portfolio is a simple approach to evaluating possible future scenarios. However, this method wouldn’t be sufficient for a well-diversified investment strategy, as it fails to allow for the interconnectedness of asset classes or changes to those connections during times of stress. On the other hand, developing complex multi-regime and “fat-tailed” distribution models may provide more detail, but these models can be extremely complex and generally lack analytical solutions.

In our view, scenario analysis that combines the opinions and judgment of experts with quantitatively determined relationships between market risk factors will create more realistic scenarios. In this way, we can determine the expected impact on our portfolios of an unforeseen event in a rational manner that does not simply assume that history will repeat itself.

To model future risk events using this type of scenario analysis, investors must first consider possible but plausible extreme future events, whether economic, political, environmental, societal or technological. Examples include events such as a potential China crisis, political risks in Europe and elsewhere, or the impact of stagflation. Experts’ views can help identify the key factors and a range of potential responses, focusing on markets with a direct causal link to the extreme event under consideration. These key factor market moves can be combined with market simulations in a manner that weights the simulations to capture the fat-tailed nature of the outcome.

To model future risk events using this type of scenario analysis, investors must first consider possible but plausible extreme future events, whether economic, political, environmental, societal or technological.

This results in a range of possibilities under a particular extreme event, rather than at a single point in time. Using this method, investors can see how well the strategy weathered the projected stress scenario in comparison with the relevant asset classes.

Lower returns expected over the long term

The global economy has entered into a period of lower returns for the foreseeable future. As emerging markets have matured, growth has begun to slow down somewhat. At the same time, developed markets have experienced persistently low interest rates for nearly a decade, and although the monetary environment has gradually begun to tighten, rates remain near historical lows. These are the realities investors must face as they search for attractive returns.

When looking at the 10-year annualized returns, U.S. equities have outperformed their international peers, as shown in Chart 4. . Unprecedented accommodative monetary policy implemented during the financial crisis helped lead the economy out of the worst contraction since the Great Depression and into a steady, if sluggish, recovery. Companies that cut costs and paid down their debts during the recovery have been rewarded with improved earnings and more efficient operations. The current U.S. administration’s pledge to reduce regulatory requirements in a number of industries, as well as the recently passed tax cuts, should provide an additional boost to U.S. companies and the overall U.S. stock market.

But investors that have most or all of their money invested in the U.S. shouldn’t become complacent. After all, there’s no way of knowing how long these conditions will persist. U.S. equity market valuations are relatively expensive compared to other parts of the world, particularly with regard to larger companies. The unwinding of accommodative monetary policies may come with its own risks, including the potential for higher market volatility and the possibility of downturns in both the equity and bond markets.

Investors that have most or all of their money invested in the U.S. shouldn’t become complacent

Opportunities for enhanced diversification

It’s time to rethink assumptions about non-U.S. investments. While the U.S. is in the midst of a gradually tightening interest-rate environment that could affect future economic growth, developed markets outside the U.S. are growing faster than they have in years thanks to their central banks’ continued accommodative monetary policies. For example, the European Union posted stronger economic growth than the U.S. recently delivered, and could grow even faster if unemployment numbers come down.

Emerging markets are looking attractive as well. Many emerging nations have begun to adopt business-friendly reforms while paying down their debts and fighting inflation. Not only do emerging markets continue to experience faster growth than their developed counterparts, but their exposure to different sources of return also provides opportunities to enhance diversification. Here are just some of the opportunities investors should consider.

  • International equity. Investing broadly across international markets boasts several advantages. First, there is a broad opportunity set from which to choose, allowing investors to be nimble as global markets evolve. Investing across these markets can also help investors access leaders in different sectors that are located outside the U.S. Since valuations are less expensive relative to U.S. equities, opportunities will be a better value for investors in general. And since there isn’t a single market that leads the global economy all of the time, investors have a better chance of benefiting from global success stories when they choose to go beyond their home market.

    Performance for international markets has been strong in recent years and in many cases has been stronger than the U.S., as shown in the chart below. Still, it’s important to be selective in choosing among the many investments offered abroad. An emphasis on fundamental research, combined with deep expertise within various regions, can help identify some of the best companies and securities in which to invest.

    Chart 4: Relative performance of U.S. vs. non-U.S. equities

    Source: Morningstar Direct, February 2018.

  • International small-cap equities. Investing in international small-cap equities can provide investors a missing piece to the diversification puzzle. The international small-cap universe, as represented by the MSCI ACWI ex USA Small Cap Index, comprises more than 4,300 companies in 46 countries and around 14% of the global market. Like U.S. small-cap equity, international small-cap equity boasts a variety of companies that are nimble and poised for significant growth relative to others in their respective sectors. And in addition a vastly expanded opportunity set of smaller companies, diversifying into international small-cap equities allows investors to access this potential for rapid growth within some of the fastest-growing economies in the world.

    Analyst coverage for international smaller companies is extremely limited, with an average of five analysts per international small company, and many companies having no analyst coverage at all. This allows savvy active managers to use their global expertise to take advantage of lesser-known opportunities that provide the potential for attractive returns.

  • Emerging-markets equity. Emerging markets have many advantages in the current market environment. They have favorable demographics, with a young and growing population. The increased urbanization of emerging nations should drive increased consumer demand and attract young workers to cities for better opportunities. And economic growth looks set to continue to outpace developed markets in the years to come. At the same time, emerging markets are becoming more stable, with many nations making necessary reforms to support a more business friendly environment while paying down their debt burdens.

    As shown in the chart below, emerging markets have experienced a gradual economic recovery over the past several years, and expectations are that this trend will continue. In 2017, emerging markets made up 50% of the world’s GDP but 10% of its market capitalization. This suggests that if emerging markets can continue to encourage businesses to lay down roots while expanding their local stock markets, investors may not only see many more publicly traded companies in which to invest but also faster growth and better returns that reflect emerging markets’ important contributions to the global economy.

    Chart 5: Percentage GDP growth, constant prices

    Source: IMF, World Economic Outlook, April 2017. Forecasts are offered as opinion and are not reflective of potential performance, are not guaranteed and actual events or results may differ materially. For illustrative purposes only.

  • Emerging-markets debt. Opportunities existing in emerging-markets debt look attractive relative to those in developed markets because of their idiosyncratic characteristics and ability to add diversification to portfolios of developed-market debt. A weaker U.S. dollar has helped support emerging-markets currencies.

    Chart 6: Average real effective exchange rate in emerging markets (ex-China, 2010=100)

    Source: BIS (Bank for International Settlements), July 2017. GDP weighted index of 17 emerging market countries Note: EMFX (emerging market foreign exchange rate) For illustrative purposes only.

    Emerging-markets local currency bonds are becoming increasingly appropriate for a wider range of investors due to their size, growing liquidity and dedicated research platforms. This trend is supported by improvements in valuation and liquidity, creating somewhat of a virtuous cycle. Historically, local banks and pension funds dominated local currency bond space; however, the institutional investor base has been growing both domestically and overseas, providing impetus for further development of the local currency bond market. The further easing of foreign investors’ access to local markets should help the overall growth of the asset class.

Alternative asset classes 3

Alternative strategies such as private equity typically add different risk exposures and provide a way to diversify portfolios consisting of traditional asset classes, making them compelling additions to portfolios for the purpose of diversification. Private equity is a complex asset class and can be difficult to navigate without an experienced manager, particularly in the high-potential global lower middle market space. But those with access to in-depth due diligence and top-quartile managers should in many cases have the ability to generate attractive returns.

Nothing stays the same

The world is constantly evolving, and we have no way of knowing when the next bump in the road will occur. At the same time, our access to more information at a faster speed creates the desire to respond to changes at a quicker pace, even if these decisions may be ill-informed.

Rather than being afraid of what lies ahead, investors who have prepared for a changing market environment by ensuring their investments are properly diversified can confidently face whatever lies ahead. Change is inevitable, but preparedness paves the way for better possibilities.

Eight ways investors can dig deeper into diversification

  1. Look beyond the here and now to assess potential future risks, develop a prudent way to measure potential risks, and have a plan in place to address them.
  2. Ensure you are making thoughtful, personalized decisions regarding your long-term asset allocation strategies.
  3. Recognize that the world’s capital markets aren’t simply a straight, well-paved highway; market volatility is a recurring bump in the road on an investment journey.
  4. New investment strategies and new market segments are continually introduced, and some may have the potential to enhance your portfolio’s diversification and lower potential risk. It’s important to keep a fresh perspective how new strategies can deliver attractive return-generating opportunities.
  5. Incorporate certain measures that help align a prudent asset allocation strategy such as tail behavior, keeping in mind that regime shifts, outlier events and even economic, political, societal and technology changes may impact the capital markets.
  6. Align your investment strategy with your personalized “road map.” Are you seeking long-term results, for your children’s college savings or your own retirement lifestyle? Or is income generation what you need most? Knowing your unique set of objectives helps you plan appropriately.
  7. Discover how the world’s smaller companies are growing, developing and innovating; don’t let established large companies be your sole investment focus.
  8. Take a look at the entire world’s investment opportunities and develop a global perspective. Examine and evaluate how an appropriate allocation to international equity, emerging-markets equity and fixed-income opportunities, and certain alternative investment strategies can help mitigate risk .

1Fat-tailed distributions occur when the distribution falls outside the normal bell-shaped curve. They arise when many events or values stray wide of the average, giving extreme high and low values. This makes the bell flatter and fat-tailed.

2Carlson, Ben. “Think Global to Avoid Shrinking U.S. Stock Market.” Bloomberg News. March 17, 2017.

3 The investments discussed herein may not be available or suitable for all investors unless the investor meets certain regulatory eligibility requirements.

ID: US-070318-58863-1


Important Information

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

Indexes are unmanaged and have been provided for comparison purposes only. No fees or expenses are reflected. You cannot invest directly in an index. 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.

Fixed income securities are subject to certain risks including, but not limited to: interest rate (changes in interest rates may cause a decline in the market value of an investment), credit (changes in the financial condition of the issuer, borrower, counterparty, or underlying collateral), prepayment (debt issuers may repay or refinance their loans or obligations earlier than anticipated), call (some bonds allow the issuer to call a bond for redemption before it matures), and extension (principal repayments may not occur as quickly as anticipated, causing the expected maturity of a security to increase).

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