Portfolio diversification plays two important roles. It helps to manage risks more effectively and it allows investors to widen their scope for capitalising on global market opportunities.
However, as market opportunities change, multi-asset portfolios work best when they respond dynamically rather than remaining static. In the world of financial markets, one year’s outperformers are often the next year’s losers. If history is anything to go by, this is as true for whole asset classes as it is for single stocks.
For example, global developed market equities did exceptionally well in 2013 and strongly outperformed UK government bonds. In 2014, developed market equities also gained, but UK government bonds outperformed them.
The difference in performance in ‘good’ and ‘bad’ years produced by the same asset class becomes more pronounced when looking at more volatile types of investments. Emerging market equities, for example, were the top-performing asset class out of 10 options in two of the 11 years from 2004 to 2014 (2005 and 2007). But they were the worst performing in another two years (2008 and 2011).
The picture is varied because asset classes do not move in tandem with each other. When multi-asset fund managers construct portfolios, they ensure effective diversification using the asset classes that are lowly correlated to each other.
As with asset class performance, correlations between asset classes do not remain constant. They change according to market dynamics and fundamentals. Managers analyse and seek to benefit from the correlations to achieve effective portfolio diversification.
A simple combination of two lowly correlated asset classes such as equities and bonds typically generates better returns with lower risk, particularly over the long term. The periods of declines for equities are normally more pronounced and longer than for bonds, due to equities’ higher level of volatility.
Taking the period between 1920 and 2015 (using data from Global Financial Data based on the performance of US equities and bonds to May 31 2015), equities declined in 25 of the past 95 years. This signifies the short-term volatility of the asset class rather than its long-term performance, as the annualised return over the period stands at 10.1 per cent, almost double what bonds delivered.
Bonds produced an annualised return of 5.4 per cent, at almost a third of equities’ volatility (6.3 per cent compared with 18.6 per cent).
Low correlation and the differences in risk/return between equities and bonds enable managers to produce a higher risk-adjusted return by combining the two asset classes 50/50 in a single portfolio.
The benefits of blending asset classes from a risk-adjusted perspective are widely accepted but it’s equally important to keep asset allocation flexible, reflecting the state of markets. This is because asset class returns are volatile, in absolute terms and in relation to each other.
Taking a ‘dynamic’ approach to asset allocation does not mean asset managers respond to every twist and turn in financial markets. They focus on long-term performance, aiming to diversify away from long periods of underperformance while capturing phases of normal or exceptionally strong asset returns.
