Benefits of diversification

Volatility here to stay A strong investor can optimise their approach using the diversification tool. The last few months have exposed how quickly the direction of the markets can change, and investors’ risk appetite with it. Volatility looks like it is not going to be a short term phenomenon. Thus to protect your assets it is important to hold as diversified a portfolio as possible. For example, whilst equities remain an attractive asset class with a return premium (over cash) of around 3 per cent per annum, they do carry with them an annual volatility of around 15per cent, which can make your portfolio returns highly variable and in the short term, require nerves of steel to stick with your long term strategy. It therefore makes sense to branch out into asset classes that don’t all behave alike but can provide similar levels of return expectation. This is indicated by the correlation. For instance, if you add North American equity to a UK equity portfolio, the correlation is relatively high at 0.74; they behave in almost the same way (complete correlation being 1.0). Choose global high yield bonds instead (correlation of 0.36) and there is less likelihood of the two moving in sync and more likelihood of the combination working together to yield more robust returns. Combining multiple asset classes with a low correlation to each other has the potential to result in a more efficient portfolio, limiting your total risk and providing better opportunity for positive returns Where else to invest? In addition to traditional equities and bonds, investment opportunities include: i) Higher Yielding Fixed Income strategies such as high yield or emerging market debt both have sufficiently attractive risk/return profiles and low correlations to equities. ii) A diversified exposure to Hedge Funds has the potential to offer a risk profile close to bonds but with marginally higher returns and a low correlation with traditional assets. They are also less interest-rate sensitive than bonds. iii) A passive exposure to Commodities has delivered broadly similar risk and returns to equities over the past 35 years. Most valuable is the negative correlation between the two classes – which means that holding commodities should help smooth the long-term performance of your portfolio. iv) Currency: is highly liquid and offers low correlation to traditional assets. It is also capital-efficient, allowing you to target higher returns without using up large portions of your assets. This in turn frees up your capital to diversify your portfolio further. v) Private Equity: many of the performance drivers of private equity are different from those of the quoted markets: private equity managers with a large network of contacts have an informational advantage over other investors, can influence the company’s strategic direction, and longer lock-up times allow them to pursue long-term growth. There are challenges to investing in private equity, but, like the other alternative investments, its appeal lies in its role as a portfolio diversifier and an attractive source of potential returns. An efficient portfolio With the advent of UCITS III, many of these asset classes are now available to investors giving more opportunity than ever before to build an efficient portfolio through making the most of the opportunities available. In today’s volatile investment markets, adding real diversity to portfolios will a much greater part of future mainstream thinking.