New rules for building a diversified investment portfolio

A diversified portfolio was once a straightforward way for investors to respond to escalating market uncertainty, but not anymore. Cherry Reynard outlines the new rules.

If history is any guide, we may be nearing the end of a strong run in stock and bond markets. At more than 3,450 days, the bull market run in equities is already the longest in history and bond markets have started to roll over. There are sound reasons for this: interest rates are rising, valuations are high and the geopolitical environment is increasingly uncertain.

New conundrum

The correct response to this new climate, according to much of the investment management industry, is diversification. Much has been made of the power of diversification, which was famously branded "the only free lunch in finance" by economist Harry Markowitz. And who doesn't like a free lunch? At its heart, diversification simply entails holding a range of assets so that as some go down, others rise, giving an investor a balanced return over time. In theory, investors could simply hold some bonds, some equities and perhaps a bit of property, sit back and watch their investment gently rise in value.

Only it's not quite that simple. Holding a 'balanced' portfolio of bonds and equities used to work pretty well. Bonds tended to do well in a weaker economic climate, while equities typically thrived when the economy was expanding. However, the various interventions of central bankers since the financial crisis have changed all that. Quantitative easing put lots of money in the system, creating demand for financial assets and pushing up stock and bond markets in unison. Those with a balanced portfolio did well, but not because they were diversified.

The danger is that as emergency monetary policy measures are withdrawn and interest rates rise, the opposite happens: bonds and equities drop in unison. Those who thought their portfolios were diversified find that they aren't.

Mark McKenzie, head of alternatives research at Thomas Miller Investments, says:

"The old rules have changed slightly. If we look back prior to 2008, a 50/50 split of bonds and equities didn't do too badly. Any sharp decline in equities was offset by bonds; but the diversification benefits of traditional models have dwindled. The question becomes how to mitigate against increasing risk from traditional portfolios."

This problem is also very apparent with income-seeking strategies. When interest rates are low, investors may look to replace the income they were previously getting from their savings accounts with stock or bond market investments. This can push up parts of the stockmarket that are seen as providing a safe income, as well as corporate bonds that pay an attractive income. The danger is that when interest rates rise, all those stocks and bonds sell off in unison because the same income can be achieved with lower-risk assets. Markets are not there yet, but there are signs that these assets have started to wobble.

Interest rate risk

If the old rules no longer apply, what are the new rules? It is possible to achieve some diversification through bond and equity markets alone. McKenzie says:

"Areas have underperformed that may be in a position to do better. For example, value has struggled within equities and the tide might be turning there."

Within bonds, investors can allocate to gilts and also to high-yield or emerging market bonds, which should behave differently at different points of the economic cycle.

However, it is difficult to diversify away interest rate risk with a pure equity and bond portfolio, and for that reason it may be advisable to include some balancing options. To do this and achieve better diversification, investors have a growing range of options, particularly among investment trusts, where new and unusual assets are being packaged up and brought to market – aircraft leasing, niche property funds and specialist credit vehicles, for example.

That said, achieving diversification may mean holding asset classes that have not done particularly well to date, or even those that may not look particularly attractive. By definition, being properly diversified means investing in areas that will do well in an environment different from today's.

John Husselbee, head of multi-asset at Liontrust, says: "If you have zero weighting to an asset class, to my mind that is not proper diversification. Plenty of funds say they are offering diversification, yet have zero weightings in gilts, for example. Some absolute return funds are negative for the year to date, but I accept that because I accept the way diversification works. Diversification means buying something that has low correlation to traditional assets. The only way to reduce overall risk is to do something totally different."

This should be an investor's starting point. It is not necessarily about a direct hedge against the market. For that, investors would need to look to a short-biased hedge fund, such as the Jupiter Absolute Return fund, or a specialist short exchange traded fund. For the most part, investors should think ‘different' rather than 'opposite'.

Gavin Haynes, investment director at Whitechurch Securities, uses commercial property, infrastructure, gold, currency and absolute return funds to help diversify the group's portfolios. But he says: "There is no point in having diversification for the sake of it, without understanding how the investments work.

"When looking to build a diversified portfolio, you need to understand the economic environment and whether assets will move in the same direction. For example, how does each area perform in a rising interest rate environment, or under inflation or deflation, or when sterling strengthens?"

There can be unintended consequences for investments. At the start of this year, the dollar was strong, prompting a sell-off in emerging markets. It's just one example of how investments can be connected in a variety of ways.

McKenzie believes parts of the property market currently offer good diversification for portfolios: He says: "Logistics are well-supported by the rise of e-commerce and healthcare property investments are also a good option. These properties have NHS tenants, so the cash flow is well-supported. They are not economically sensitive and should do well in more challenging environments." He also likes infrastructure and private finance initiative assets.

Popular choice

The targeted absolute return sector is often a choice for those looking for diversification. However, says McKenzie, it is a broad sector and investors must ensure they are getting the diversification they expect. Some long/short equity funds have moved largely in line with the wider stockmarket and therefore provide little diversification from a standard equity portfolio. Investors should look for funds with low drawdowns, a low beta score (a measure of how correlated a fund is with the wider stock market) and low volatility.

The fund management industry saw Ucits hedge funds as a good source of diversification for investors, but interest has been falling rapidly since 2013. These 'liquid alternative' funds saw inflows drop from $53 billion (£40 billion) in 2013 to just $6 billion in 2017, according to Morningstar. However, it is worth remembering that the time to buy insurance is not when the roof has already fallen in, and that strong inflows may not be a good guide to the right time to buy.

Gold is often seen as an escape from difficult markets and has proved a diversifier in the past. However, McKenzie cautions that it doesn't work well in all ‘risk off' environments and has often performed poorly when interest rates are marching higher. It is a hedge against currency weakness more than interest rate risk, but the price of gold is at an 18-month low at the moment, so it looks cheap relative to recent history.

Investors should look beyond conventional bond and equity markets to weatherproof their portfolios against a more difficult economic environment. There are plenty of options, but achieving true diversification may mean delving into difficult areas and asset classes.

Multi-asset routes to diversification

Past performance is not a guide to future performance.

Investors looking to achieve greater diversi­fication in their portfolios have two main options. They can pick out individual funds or they can invest in multi-asset funds that do the hard work for them.

Currently, relatively few of this type of fund are available and they are not always easy to spot. Overall, many have been successful at providing a regular, consistent return and/or income to investors, perhaps more so than many targeted absolute return funds.

These funds take a variety of approaches. The Miton Global Opportunities fund, for example, is built from investment trusts. The Architas Diversi­fied Global Income fund has an income focus and has generated a historic yield of more than 5%. However, they all provide a one-stop shop for alternatives exposure.

Full performance can be found on the company or index summary page on the interactive investor website. Simply click on the company's or index name highlighted in the article.