26May 2016

Mike Brooks

Head of Multi-Asset Growth Strategies

A diversified approach: learning from the lizard

The common basilisk owes its nickname of the Jesus Christ lizard to a highly distinctive skill: like Christ on the Sea of Galilee, this reptile can walk on water. It does so by spreading its body weight across a wide surface area.

This is, in a way, how a diversified investment approach works: managers extend their investment across a broad range of asset classes to avoid sinking to the murky depths, where prices languish deep under water.

The downside of single-asset investing, based on a portfolio of equities, has been learnt too late by many an investor. Equity markets are volatile and can underperform cash over periods of ten years or more. An investor who earmarked all their money to equities at the start of the millennium would not, until 2013, have beaten another investor who’d put all their money in cash.

The standard way of coping with the fickleness of equity returns is to allocate a large amount to highly rated bonds. This double-asset investing has sometimes worked well, but as a piece of investment wisdom, it is not as timeless as many think. Equities and bonds provide good diversification when they negatively correlate with each other. However, if we look at the correlations of five-year rolling returns for the S&P 500 stock index and US Treasury bonds, for example, there have been only two periods of negative correlation since the Second World War: 1955-65 and 2000-15. The rest of the time they have tended to move in the same direction, often in response to inflation. This makes sense: if inflation rises more quickly than expected then the resulting interest rate rises aimed at taming inflation are typically negative for both bonds and equities.

A diversified approach provides a solution to the problem that stocks and bonds have often behaved the same way, but how diversified should your portfolio be?

The more asset classes the merrier – provided each asset class has the capacity, over time, to produce an attractive return. Using a lot of asset classes tends to support the stability of the portfolio more than just using a few, because it increases the likelihood that in times of market stress some assets will rise or retain their value while others are falling.

For example, during the great financial crash of 2008-9, stock prices fell, yields on corporate bonds soared, and even many hedge funds made huge losses. But while the value of emerging market equities dropped 30% in 2008, the value of some local currency emerging market debt rose 30%. For those investors who had wisely cast their net widely, solace came from this unexpected source. And this wasn’t the only asset class to make a profit during the financial crisis. Other specialist asset classes, such as infrastructure, catastrophe bonds and managed futures also delivered positive returns during this period.

There is no shortage of asset classes to provide multi-asset strength. We estimate that up to 20 can be considered – with some new ones sprouting up in the past decade. Some show either no correlation with mainstream financial markets, or very little indeed. Catastrophe bonds are based on meteorological events. Renewable energy projects provide good long-term yields backed by government subsidies rather than the strength of the economy and corporate profits.

Investing in a wide range of asset classes also gives investors the flexibility to exit some temporarily if prospects look poor. We estimate that a well-constructed multi-asset portfolio, which includes a broad range of suitable investments, should provide an average return of cash plus 4.5%, net of fees. This is similar to average long-run equity returns, but comes with half the volatility.

Investors might sometimes feel that they don’t need multi-asset investing because they have a clear and confident view of what the global economy, and hence financial markets, are going to do. In such a case, they could take a bullish view through equities, or a bearish view through government bonds, though the latter would produce unspectacular returns even if investors had called the global economy correctly, because yields are already so low.

But at this particular moment in history, the crystal ball is even more clouded than usual. The sequence of global interest rate rises predicted in 2015 may come to a halt or even go into reverse. The price of oil, which has fallen at times to a mere quarter of mid-2014 levels, could slide further or bounce back up again, depending on unknowable geopolitics as well as unknowable economics.

A diversified approach is a good way of responding to this uncertainty. It’s time to follow the example of the Jesus Christ lizard.

Mike Brooks, Head of Multi-Asset Growth Strategies

Image credit: © Ingo Arndt/Nature Picture Library/Corbis


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