In the current low interest rate environment, investors are having to cast their nets wider for sources of return. Here we examine why greater diversification can be beneficial and how advisers can help clients achieve this.
May we live in interesting times
It would be no exaggeration to say that the world is currently facing unprecedented challenges and uncertainties including geopolitical risks, regulatory reform, climate change and disruptive demographic trends.
Similarly seismic shifts are occurring in financial markets, where there is evidence that the established relationships between asset classes are weakening and the prospect for investment returns are less rosy.
Where once traditional diversification methods may have provided investors with an adequate degree of protection from losses and the potential for outperformance, these benefits have reduced in the current environment. Increasingly, investors are recognising that they are unlikely to enjoy the stellar bond and equity market returns that they may have experienced in the past decade and that traditional approaches to managing portfolio risk may not provide the same protection in future.
So how did this environment arise?
During the past 30 years, developed market equities and bonds saw returns well-above their long-term averages. Driving these exceptional gains was a confluence of economic and business trends. These included sharp declines in inflation and interest rates from the unusually high levels of the 1970s and early 1980s. Similarly, global GDP growth was strong, lifted by favourable demographics, productivity gains and rapid growth in China. We also saw stronger corporate profit growth, reflecting revenue from new markets, declining corporate taxes and advances in automation and global supply chains that helped contain costs.
Now though, a number of these forces are weakening or even reversing. Global productivity growth for instance has slowed dramatically, particularly since the 2008 global financial crisis (GFC). As a result, future investment returns for developed market equities and sovereign bonds are likely to fall short of the returns of past decades. We now find ourselves in a world of low numbers, with historically low rates of economic growth, inflation and interest rates – but with heightened uncertainty.
Markets break from tradition
Investors have long sought investment strategies that promise lower-risk growth. The traditional approach to achieving growth while managing market uncertainty has been to invest in more than one asset class. Diversified growth funds (DGFs) typically invest in a mix of equities, bonds and property on the premise that different factors drive each asset class so that, should one fall, another can be expected to compensate.
History shows that a diversified growth approach has generally worked well under 'normal' market conditions: when equities have gone down, bonds have risen and vice versa.
However, in periods of extreme market stress and uncertainty, the various asset classes tend to fall in unison. This became starkly evident during the 2008 GFC, when global financial markets collapsed and exposed the diversification offered by DGFs to be 'fair-weather'.
And where once government bonds and equities were negatively correlated (moving in the opposite directions), monetary support from central banks since the GFC, in the form of quantitative easing for example, has led them to be much more correlated.
So with traditional diversification methods likely to be less effective, there is a need for more efficient ways of controlling investment risk. What are the options?
The quest for genuine diversification
The ultra-diversified approach taken by some multi-asset investment propositions is one way to help clients effectively navigate market uncertainty, dampen volatility and deliver returns. Such approaches invest not only in equities, bonds and property but can also bring alternative assets into the investment equation such as infrastructure or renewable energy. They can also seek to profit from the manager's views on other key drivers such as interest rates, inflation, volatility and currencies, and are designed to provide returns at times when traditional asset classes may be faltering.
Additionally, the facility to take both 'long' and 'short' positions means these funds can invest in 'relative-value' strategies, allowing them to target positive returns irrespective of whether markets are rising or falling. For instance, a portfolio manager might have a positive view on US banks (predicated on the health of the US economy) but a negative view of US consumer companies (given the challenge from online retailers). The manager can seek to profit from these views by taking a long position in US banking stocks and a short position in US consumer stocks. Importantly, even if the overall US equity market falls, this position can still make money, provided the bank sector outperforms the consumer sector.
Navigating the 'new normal'
Undoubtedly, investors seem set to face a future where markets are likely to be volatile and returns fall short of their historic averages.
In this environment, a highly-diversified multi-asset approach that seeks genuine diversification can offer demonstrable benefits, both in enhancing return potential and dampening risk.
The value of an investment is not guaranteed and can go down as well as up. An investor may get back less than they invested. Past performance is not a guide to the future.