A practical guide to diversification
The opportunity set has increased for most investors over the past two decades. But what are the practical issues that an investor needs to tackle to construct a diversified portfolio?
Until recently, only the world’s most sophisticated institutional investors had access to many alternative asset classes. University endowments, sovereign wealth funds and major pension funds share the ability to assess and access the widest range of opportunities. Such investors are able to invest in less liquid investments. And they have the resources to conduct research and due diligence on markets requiring specialist knowledge.
Various developments, including the evolution of the listed alternatives market, have increased the accessibility of these asset classes. This gives individuals investors access to a genuinely diversified portfolio. However, there are practical considerations in managing a portfolio that exploits this diverse range of opportunities. Investors must be able to:
- assess the return and risk characteristics of each asset class
- select the appropriate investments
- manage allocations on an ongoing basis
- ensure that risks are appropriately managed.
Assessing return and risk
Genuine diversification comes when a portfolio is exposed to different risk factors.
What drives asset class returns? Each asset class can be thought of in terms of bundles of risk premia. Understanding these different risk premia allows investors to build a better understanding of the risk and return of the asset class. Genuine diversification comes when a portfolio is exposed to different risk factors.
- The equity risk premium, for example, compensates investors for being at the back of the queue to get their money back when things go wrong. Equities also tend to fall during economic recessions, when investors most need their wealth and risk aversion is at its most acute.
- The bond ‘term’ premium compensates investors for the risk that future inflation and interest rates will diverge from expectations.
- Corporate bonds offer a credit premium over government bonds in compensation for the risk of default.
- Private assets enjoy an illiquidity premium, compensating investors for the risk of not being able to access their capital when they need it.
The combinations of different risk premia for major asset classes are illustrated below.
Source: Aberdeen Standard Investments, June 2019
An investor’s goal is to understand the risk factors that drive these premia. They must assess whether the premia are sufficient relative to the risks at current valuation levels.
Strategic asset allocation incorporates valuation levels to predict long-term returns . For example, the equity risk premium varies substantially over time. When times are good and investors are optimistic about the future, risk premia can compress to low levels. This means expected returns are also low. By contrast, in the midst of a recession, investors’ need for capital and their risk aversion increases. The equity risk premium expands, sometimes to double digits, driving expected returns higher.
Strategic asset allocation aims to improve returns by providing a disciplined process for recycling capital from expensive assets to cheaper ones – those with higher risk-adjusted expected returns.
The key to diversification is to find assets whose returns are driven by largely independent factors. Equity returns are closely linked to the business cycle. Therefore effective diversification requires assets whose returns are not affected by this cycle. This is where finding new asset classes and understanding the different drivers of return pays dividends.
Investors also need to consider risks and opportunities associated with environmental, social and governance factors. The need to reduce carbon emissions has driven demand for renewable energy – and a need for capital to finance its development.
Good governance is a key consideration for investors accessing alternative assets through investment companies. Share price movements do not always follow the movement in underlying values. If a share price trades at significant discount to the underlying value, the board of the company can act to support the share price. The company can sell assets and use the proceeds to buy back shares. If the discount persists despite these actions, investors can trigger a continuation vote: asking for all assets to be sold and the proceeds returned to shareholders.
This time is different?
Another key component of strategic asset allocation is forming a view on how the future will be different from the past. Structural economic change can have a dramatic impact on asset class returns. Historical investment returns reflect yesterday’s economic and market circumstances and are not a reliable guide to the future.
Government bonds provide the key example. This asset class has delivered returns of 5% – 7% over the past 20 years. Will it continue to do so over the next 20? This is almost mathematically impossible. Central bank interest rates are well below average in the US and near zero in Europe and Japan. The term premium, the additional yield earned for holding longer-dated bonds, is also low, around 0% versus a long-term average of between 1% and 2%. Consequently, yields on long-dated bonds – and hence expected returns – are unusually low.
Over the longer term (five to ten years), economic developments are driven by secular factors such as trends in demography, productivity, inflation and equilibrium interest rates. How will ageing populations affect economic growth? How will today’s weak business investment affect future productivity? Will the global savings glut persist in depressing interest rates?
However, over the medium term (three to five years), markets are driven more by the familiar pattern of recession and recovery associated with the business cycle. They respond to related credit and policy interest rate cycles. Within this shorter time frame, the risk premia of economically exposed assets vary substantially and are a key driver of returns.
The most attractive opportunities change over time. Asset allocation should be dynamic rather than static. Portfolios should be positioned to benefit from the future expected return and risk environment, rather than the past. No asset class should be guaranteed a place in the portfolio.
Building a diversified portfolio
A successful outcome requires expert portfolio construction. Multiple factors need to be considered in setting the asset allocation.
Investors need to consider the overall balance of investment objectives in terms of return and risk characteristics. Different asset blends can target particular return outcomes and offer different risk characteristics. For example, a different approach is needed if the focus is to reduce the risk of capital loss rather than managing risk relative to a benchmark or peer group.
The earliest investors concentrated on total return. Since the 1980s, the focus of the investment industry in the 1980s and 1990s has shifted to returns relative to a benchmark or peer group. This has led many investors to cluster around very similar asset allocations, with risk and return highly sensitive to equity and bond markets. These portfolios have delivered good long-term returns, but risk characteristics have been variable due to changing underlying correlations.
The investment industry can do far better. It can refocus on investors key goal: delivering long-term returns while managing the risk of capital loss.
The role of portfolio optimisation
In theory, it is possible to use optimisation techniques to identify the ideal portfolio. This can be calculated using the return and risk objectives for the portfolio, and the expected return and risk characteristics of each asset class. But investors should treat the results of any optimisation with caution. The ‘optimised’ mix is typically concentrated in a few asset classes and allocations are sensitive to small changes in the input assumptions. These assumptions are inherently uncertain in reality.
In practice, a broader perspective on risk leads to a more diversified approach. This is found to be more robust when actual returns inevitably differ from the forecasts. Investors should adopt a pragmatic approach to reflect the degree of uncertainty in future risks and returns and to avoid concentration risk. A more qualitative assessment is needed to diversify the underlying drivers of return. Judgement is required alongside quantitative analysis.
A broader perspective on risk management
Statistical analysis has become more sophisticated over the past 30 years. Investors are increasingly reliant on backward-looking models of risk. However, not everything that is important can be measured, and not everything that can be measured is important.
Investment markets are driven by human emotions – particularly greed and fear. Markets can move from relative calm to chaos in a short space of time. At these turning points, standard risk models can be found wanting. It is therefore important to have a forward-looking perspective on risk.
Scenario analysis considers what might happen in different possible futures. Incorporating extreme events allows investors to understand how resilient their portfolios might be. This can throw up some very different results to backward-looking risk models.
Risk models using data from the past 30 years assume that government bonds will do well if equities sell off. This is because most market shocks have been growth shocks with deflationary effects. However, going further back to the 1970s, equity market sell-offs were triggered by inflation shocks. In those instances bonds sold off as well.
The next crisis could be characterised by inflation concerns – due to a global trade war or an oil price spike. In that scenario, portfolios that depend on government bond prices moving in the opposite direction to equities are likely to suffer. Indeed, in recent years bonds and equities have become increasingly positively correlated. Falling interest rates, supported by quantitative easing, have boosted both equity and bond prices. Just as there has been a positive correlation on the way up, so there may be on the way down.
Investors should also consider liquidity risk. Listed alternatives offer daily dealing in their shares. However, their liquidity is similar to other small or mid-cap equities so holdings need to be sized appropriately. It is important to not own too high a proportion of any company. Analysis should include gaining an understanding of whether a large portion of their stock is held by any single investor, whose actions could distort the share price. Within these constraints however, the long term investor can potentially alter their position to benefit from temporary discounts or premia to net asset value.
All investments come with risks. Social infrastructure is subject to political, regulatory and project specific risk. Renewable infrastructure is exposed to power price risk. And litigation finance faces risks associated with individual cases. The key benefit of a diversified portfolio is that these are largely independent risks – and unrelated to the economic risks associated with equity markets.
Editorial image credit: EschCollection / Getty Images
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