Diversification in Multi-Asset Portfolios
- 8 minutes
- Iain McGowan - Director, Investments, Scottish Widows
- June 2020
Making the most of Diversification in a Multi-Asset Portfolio
Since the 2008 financial crisis, multi-asset funds have grown in popularity among investors seeking to manage risk and protect capital while also targeting growth. At the time, the crisis had focused attention on the risks inherent in investing in a single asset class, which helped shape the rise of multi-asset portfolios.
And following the unprecedented events resulting from the Covid-19 crisis, the benefits of portfolio diversification are back in the spotlight. In March 2020, during the worst of the market downturn, no asset class was spared from the dramatic sell-offs. But in the aftermath, the divergence in performance between sectors, regions, and asset classes has reinforced the view that different types of investments will behave differently under prevailing market conditions. The relative performance of asset classes to each other is called correlation and, along with expert asset allocation, it forms the foundation of diversified, multi-asset investing.
An asset class that behaves independently of others is said to have low correlation, or to be non-correlated. And this quality is part of what makes something an appealing addition to a multi-asset portfolio: because it behaves differently, it can often help mitigate losses when other asset classes see negative returns. Conversely, it may not perform as well when other asset classes have strong returns. But asset allocation within multi-asset funds has moved on significantly from the classic ‘balanced portfolio’ split of 60% equities/40% bonds, for example. Many multi-asset offerings are now far more diverse and sophisticated.
Within asset classes, you can diversify even further. For example, with equities, you can choose between developed and emerging markets, or by region, market capitalisation, and sector. With bonds, you can split between government and corporate bonds, and particularly within the latter, there’s a wide array of credit ratings, durations, and rates that can bring new and different attributes to a portfolio.
Emerging Market Government Debt (EMGD)
Looking at one example, Emerging Market Government Debt (EMGD) are bonds issued by governments in emerging market countries (those with developing economies), which can be issued in either US dollars or local currencies. Adding an allocation to EMGD can provide a diversification benefit, due to its historically low correlation with other asset classes, and the opportunity for further diversification by country, credit rating, or currency. In addition, EMGD typically offers higher yield and potentially higher income, particularly useful during periods of low global interest rates.
Real Estate Investment Trusts (REITS)
REITs (Real Estate Investment Trusts) are another interesting example. These are a unique hybrid, of sorts, between equities and directly investing in physical property. REITs are pooled investment vehicles that own, finance or manage real estate that generates income, especially commercial property such as shopping malls, apartment buildings, or industrial warehouses. REITs are traded like equities and are much more liquid than physical ‘bricks and mortar’ property investments. In addition, REITs have delivered a steady income stream through a variety of market conditions, from the rents paid on the properties, so they can often provide higher yield than other investments during times of low interest rates. And they historically have a low correlation with other asset classes, making them an attractive diversifier.
Each asset class has a different risk/reward profile and could potentially perform quite differently over short and long-term time frames. Expert asset allocation is at the heart of deciding the diversification within a multi-asset portfolio, and ensuring that the investments remain appropriate for a client’s investment objectives and risk tolerance, and support good long-term outcomes.