As the COVID-19 crisis shows, finding assets which aren’t correlated with one another is increasingly difficult
Diversification is only one side of the coin
Diversification is the only free lunch, according to the economist Harry Markowitz, one of the pioneers of modern portfolio theory, and the perceived benefits of diversification have become almost sacrosanct in the minds of most investors.
A recent survey of private investors who use Kepler Trust Intelligence as a primary research tool, for example, found that while most have no ‘target allocation’ toward equities or bonds, and no real consistency in terms of how often they look at their portfolios, an overwhelming majority (80%) were running large, varied portfolios with more than 15 constituents, and cited diversification as the most important factor they consider for portfolio construction.*
But diversification – in the sense that ‘more is more’ – is only part of the story. In order for diversification to work, correlation between the assets one holds must also be taken into account.
Most of the private investors who use our website for research are well informed, using our research to manage sizeable SIPPs, so perhaps it is no surprise that 73% of our survey respondents also said that the correlation between their investments is something they consider before making any allocation in their portfolio.
The problem is, as the Covid induced market sell-off showed, that finding asset classes which fit this description is increasingly difficult. Equities, bonds, property – and even wind-farms – dropped in tandem as the extent of the pandemic became clear.
So, how does one achieve real diversification?
The traditional answer to this conundrum would be to blend equities and bonds in a portfolio, perhaps in a 60/40 split. However, this solution has become increasingly unsatisfactory in recent years. As correlations have risen – especially between long-only bonds and developed market equities – the risk management benefits of this strategy have waned.
A better option is to look at alternative assets. Real asset classes such as property and infrastructure have proved to be key sources of uncorrelated total returns in the past few years, with their emphasis on income as the primary driver of returns. At the same time, esoteric asset classes such as private equity have produced strong NAV growth in a period when global public equity markets have largely moved together. In all these cases, the investment trust structure’s inherent liquidity gives private investors access to diversifying investments, which over the long term should reduce risk.
Given the number of moving parts involved, trying to build a portfolio of assets which are not correlated to one another is a tremendously difficult and time consuming job. However, a number of funds that explicitly aim to produce positive returns regardless of what is going on in the rest of the market offer access to portfolios of this type.
One such example is BH Global Ltd, a listed global macro hedge fund which aims to deliver strong risk-adjusted NAV returns in all market conditions.
It invests in a range of trading strategies across multiple asset classes to achieve this, with the cumulative outcome being its historic tendency to generate returns irrespective of the direction of bond or equity markets. This was exemplified in the first and second quarters of this year. As the coronavirus pandemic plunged global equity markets into negative territory, BH Global saw strong returns, with its NAV outperformance of equities reaching over 40% on a rolling monthly basis at various points during the crisis. Importantly, once equity markets started to recover, BH Global continued to generate positive returns, which have now reached 14.8% (to 5th June 2020).
Ruffer Investment Company is another example. Sitting in the AIC Flexible Investment sector this trust – one of the standout performers in 2008 – has delivered positive share price returns of 9.21% since the start of the year while the FTSE 100 is down by 17.9%.
With a very broadly diversified portfolio of equities, bonds, index-linked bonds, physical gold and derivatives, the managers seek to balance different strategies, which in combination should generate growth in different environments, against the managers’ qualitative assessment of the coming market cycle.
Like BH Global it is an absolute return fund. It aims to deliver positive returns (after expenses) of at least twice the Bank of England base rate, and avoid losses over rolling 12 month periods.
As a tool to add genuine diversification to a portfolio, rather than simply adding more funds which will move in tandem with one another, these funds have shown themselves to be among the sharper options in the box.
*survey ran from 15/05-31/05 this year with 146 persons completing survey entirely.
These views are those of the author alone and do not necessarily reflect the view of The Share Centre, its officers and employees