Q&A with Craig Mackenzie

1) Why is it important to diversify your investments?

Fundamentally, diversification is about reducing risk. Well-diversified portfolios should be less volatile which helps smooth investors experience in choppy weather. This is particularly important now that market turbulence may be returning. With US interest rates on an upward trend, bond yields rising and equity markets still close to all-time highs, we may be entering a period of considerable uncertainty in financial markets. After an unusually protracted period of calm, volatility has made an abrupt return to the market in recent weeks.

Meanwhile, global politics offers plenty of potential for turbulence. The implications of the ongoing Brexit process are still uncertain, and the implications of the Italian elections are still unclear. In the US, President Trump is threatening a trade war through the imposition of tariffs on steel and aluminium. In Asia, North Korea remains a considerable source of risk, while President Xi’s removal of the limit on his own time in office offers further potential for geopolitical stress.

Monetary policy could also spark a sell-off in markets. With much of the slack taken out of the global economy, there is potential for a sharp rise in inflation – and therefore faster-than-expected tightening of monetary policy by central banks, which are already engaged in unwinding the unprecedented monetary stimulus of the past decade.

All of this means that investors need to ensure that the assets in their portfolio are sufficiently diversified to dampen the impact of volatile equity and credit markets.

2) How should investors gauge whether or not they're properly diversified?

In the current environment, investors cannot afford to be complacent about diversification. The past decade has seen periods of very high correlations between asset classes – even those traditionally seen as ‘alternative’. As both equities and bonds have risen, a number of previously ‘alternative’ asset classes have become increasingly mainstream, as investors have sought both protection against market stresses and sources of yield in an environment characterised by rock-bottom interest rates.

The problem is that as ‘alternative’ asset classes become mainstream, their returns become more correlated with other mainstream classes. Emerging markets, high-yield bonds and property have all moved into the investment mainstream in recent decades. More recently, private equity and absolute return have become increasingly common components of portfolios. And as these assets become more commonplace, they become increasingly subject to the same liquidity pressures as conventional asset classes – which makes them more likely to sell off in tandem.

So it is important to check that diversifiers are genuinely still fit for purpose, and, if not, to consider ‘alternative alternatives’ – often asset classes that are less liquid and less well known.

3) What are some attractive opportunities for diversification in today's market for someone invested primarily in developed markets equities and bonds?

Examples of the ‘alternative alternatives’ that can offer genuine diversification within a portfolio include insurance-linked securities, renewable-energy infrastructure and litigation finance. Typically, returns from these more esoteric alternatives are based on cash flows that are insensitive to the economic forces that drive equity and credit returns. In addition, they tend to be held by more specialised investors, which makes them less vulnerable to panic selling when the bond or equity markets decline.

Another interesting area is emerging-market government debt. Emerging-market local-currency bonds offer a substantial yield premium over their developed-market peers and their returns are less sensitive to the gyrations of equity markets. There are caveats here, of course; although emerging-market bonds are a far more dependable asset class than in the past, they are priced in emerging-market currencies and so, even though these currencies are around fair value, they do result in exchange-rate volatility.

4) What are some common mistakes investors make when they aim to diversify their investments?

The biggest mistake many investors are making today is to rely mainly on high-grade government bonds and investment-grade corporate bonds for diversification. This is a mistake because the expected returns for these bonds are extremely low. Combining equities with very low-return bonds results in relatively low-return portfolios. Using the kind of alternative diversifiers discussed above offers better results.

On top of that, there are some questions about the extent to which these bonds will offer diversification. Equities and government bonds have exhibited negative correlations in the last decade. However, over longer histories, equity-bond correlations have been slightly positive on average. Although we continue to expect government bonds to offer some protection in an equity-market crash, it is quite possible that rising interest rates will result in lower returns for both bonds and equities in the next couple of years.

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.

The views and conclusions expressed in this communication are for general interest only and should not be taken as investment advice or as an invitation to purchase or sell any specific security.

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