Why diversify when equity returns are so strong and volatility moderate?

Global equity markets have produced very strong annualised returns of over 20% in the past 18 months, with volatility as low as 6%. Risk has not really disappeared though as recent equity market corrections remind us. Recent strength in equity markets masks the variability of longterm performance. What was the annualised total return from the S&P 500 Index from 2000 to December 2017? It was not cash plus 5% or cash plus 7%: those returns annualised at just cash plus 3%. Equities can indeed perform well over several years, but they can have long periods of weakness too.

You wouldn’t start from here

One way to look at how equity and bond markets might perform over the next few years is to look at how expensive assets are you invest. It appears that the more expensive the starting point, the lower the expected return over the next 12 months may be. On most measures, equity valuations are well above average, possibly close to historic highs. Interestingly, bonds are expensive too: here, longer-term returns relate closely to the yield at the purchase point. Today, with bond yields close to historic lows, the strong bond returns of the last 20 years may be a thing of the past.

There are also structural challenges facing longerterm investors including demographics, the fading impact of trade globalisation, and China’s adjustment to a slower growing economy. Meanwhile, a savings ‘glut’ driven by QE programmes and the baby boomer’s savings, makes the search for yield challenging; and it is getting worse.

Bridging through diversification

So what can we do? Many managers try to be bolder in their market timing, to smooth returns, and generate extra performance. However, seeking to add consistent return in this way can be challenging and can conflict with managing risk. We believe that it is better to diversify portfolios. With a greater range of return drivers, an attractive return should come through more consistently. When there is a lower reliance on equities to deliver growth, portfolios should be more resilient in the event of sharp stockmarket falls.

If we reduce our allocation to equities and bonds, we need to add other sources of potential growth. One option would be to make greater use of asset classes that are accessible to institutional and retail investors alike. These include higher yielding opportunities in credit; global loans, private debt and aircraft leasing, and real assets, such as renewable infrastructure and social housing. There are specialist opportunities as well, such as insurance-linked securities and healthcare royalties. With genuine diversification comes lower portfolio volatility and more ways to generate growth and income. All these opportunities can be accessed today in a daily dealing format so we can incorporate them in our multi-asset solutions.

Using traditional assets in a different way

We can respond to the dynamic and inefficient nature of markets to seek returns. For example, holding the Japanese yen (a defensive currency) versus the Korean won (linked to global economic growth), can help mitigate falling equity prices. Investing in European bank shares relative to the whole European equity market offers the potential for positive performance if interest rates rise.

There are clear challenges ahead for traditional asset classes and for multi-asset solutions that rely on them. Thankfully, there are also more ways for us to diversify portfolios to bridge that gap. Over the years, we have independently developed two strategies to deliver this: one focused on diversification by asset class, the other offering diversification across strategies. Both, we believe, can deliver a compelling long-term return.

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