Make sure your portfolio is really diversified

This scenario may be incredibly beneficial for equity investors and those with more diversified portfolios in the short term, but it should prompt concerns about correlations between asset classes. If safe havens move in the same direction as equities when markets are rising, it suggests that they could also fall together when conditions become more difficult. And equity markets face many challenges, for example the coronavirus is having an effect on markets and disrupting companies around the world such as Apple (AAPL:NSQ), which has recently warned that the outbreak will hit its revenues. Investor sentiment in Germany, meanwhile, has weakened following the outbreak and recent data suggests that Japan’s economy has been hit by a rise in the consumption tax.

So even if you are a long-term growth investor with a high risk appetite, you should still consider how closely your portfolio is linked to the ups and downs of equity markets, and how exactly you can achieve reliable diversification.

One way to measure this is to analyse correlations between equities and other assets. Diversifying within your equity exposure can have many benefits but, as the first table below shows, different equity markets can be very interlinked. The S&P 500 index, which has led returns in recent years, had one-year correlations of 0.99 to MSCI World index, 0.87 to FTSE Europe ex UK index and 0.74 to the FTSE All-Share and MSCI AC Asia ex Japan indices, as of 18 February. A reading of 1 represents a perfect correlation, while a negative correlation suggests that the relevant asset classes should behave differently from each another.

Source: FE, 18 February 2020

The connected nature of economies and markets can also be seen in the performance of equity indices in recent years. The volatility of 2018 left no major index unscathed, with falls of between 0.41 per cent, in the case of the S&P 500, and 9.8 per cent for FTSE Europe ex UK, in sterling terms. The opposite scenario occurred in 2019 when these markets made double-digit gains in sterling terms, led by the S&P 500 which rose 23.9 per cent.

So it is worth considering other asset classes. Correlations can change over time and are not a reason in themselves to favour or avoid an investment. But they are one metric to bear in mind when you are trying to diversify your portfolio.

How correlations stack up

The second table outlines the one year correlations of the S&P 500 and FTSE All-Share with indices of other assets. For areas where funds tend not to have a common benchmark, we have put in the fund sector average correlation to a market. 

Source: FE, 18 February 2020

The data shows that fixed-income instruments continue to have a low or negative correlation to equity markets, despite having risen in tandem with stock markets, which is good news for investors with traditional balanced portfolios composed of equities and bonds. Correlations are limited on both a one and three-year time frame but have recently been lower or more negative.

The Bloomberg Barclays Multiverse index, a broad benchmark of different bonds, has a negative correlation with the FTSE All-Share and a low correlation with the S&P 500. UK government bonds appear even more defensive, despite the fact that they performed strongly last year and appear more aligned with stock markets recently.

Chris Iggo, chief investment officer for core investments at AXA Investment Managers, says that the S&P 500 fell on nine out of the first 25 trading days of this year. US government bonds held up well during those down periods – as they are expected to.

“On each of those nine days that stocks fell, the total returns of the US Treasury bond market were positive,” he says. “The correlation between equity and bond price moves has been at a negative 0.72 so far this year. For the whole of 2019, based on daily total returns, the correlation was -0.51. With equities relatively expensive, at least in some markets, and earnings growth yet to be convincing, it is important to reflect on the role that bonds can play in protecting [against] downside.”

But not all fixed-income exposure is a good diversifier. High-yield bonds, which can offer higher income and total returns, have a notable correlation with equity markets. So high-yield bond funds are unlikely to be a defensive element within your portfolio if equity markets take a tumble.

Similarly, some strategic bond funds can have large allocations to high yield, which has helped their performance but could leave them vulnerable to changes in equity markets. For example, Artemis High Income (GB00BJT0KR04) and Schroder Strategic Credit (GB00B11DP106) had around 50 per cent of their assets in high yield – bonds with a credit rating lower than BBB – at the end of 2019. 

Strategic bond funds can be very different from each other in terms of their asset allocation. Some, for example, have little or no exposure to high-yield bonds, and focus on defensive debt such as investment-grade corporate and government bonds. But the sector’s overall correlation of 0.52 with MSCI World index shows that there is a potential link.

Targeted Absolute Return sector funds, on average, have tended to be less correlated with equity markets recently. But in this sector too you should check each fund that you are interested in individually, as they can be very different from each other. Many Targeted Absolute Return funds have also not performed well in recent years, while others that had previously struggled have recently done better, a notable examples being ASI Global Absolute Return Strategies (GB00B7K3T226).

But Jupiter Absolute Return (GB00B6Q84T67), whose manager James Clunie had been short-selling names such as Tesla (US:TSLA), has been caught out by the rise in tech stocks and broader markets recently. The fund has lost 15.3 per cent, 19.4 per cent and 9.3 per cent over one, three and five years, although could prosper if there is a market downturn.

As we pointed out in the Big Theme of 24 January, gold and property can be useful diversifiers, but the way you get exposure to them can make a big difference. And this point is reiterated by the correlation figures. FTSE Gold Mines index, for example, has tended to have a low or negative correlation with equity markets over one and three years. But this index tends to have a slightly higher correlation to broader stock markets than the gold price.

But over the past year physical property has had a higher correlation to equities than property securities. Over one year to 18 February, the IA UK Direct Property fund sector average had a correlation of 0.2 with the FTSE All-Share. But the IA Property Other sector average had a correlation of -0.14. However, this could be a temporary occurrence linked to Brexit. The UK’s exit from the European Union has had a significant impact on sentiment on UK commercial property, and while direct property funds tend to focus on buildings in this country, funds that buy shares in property companies are more likely to have holdings listed outside the UK.

The investment case

Before adding a fund or introducing an asset class to your portfolio it is important to consider the wider picture. Just because some investments have exhibited low correlations with equities when they fall doesn't mean that they are suitable for you or that the asset class has good prospects.

Although bonds have continued to be reliable diversifiers there are a number of drawbacks. Demand for defensive assets has left government and investment-grade bonds on high prices, which might be vulnerable to shocks. As a result they offer little in the way of yield, meaning that if you have exposure to them it should be because of their diversification benefits rather than for income.

And some professional investors find their high prices offputting. Ben Lord, a fund manager in M&G Investments' fixed-income team, recently noted that areas such as high-quality sterling and European corporate debt look expensive versus their median levels since 2006. He added that, although recent low levels of growth and inflation are positive for these assets, he is "watching the credit market largely from the sidelines" because of the high valuations.

But if you can stomach these challenges, strategic bond funds may still appeal because of their flexibility and ability to adapt to changing market conditions. Jupiter Strategic Bond (GB00BN8T5935) and M&G Optimal Income (GB00B1H05718) have notably defensive positions at the moment, with large allocations to government bonds and higher-quality corporate debt. If you prefer a fund more focused on government debt but which still has a flexible mandate, Allianz Strategic Bond (GB00B06T9362) could be a good option.

For gold exposure, physical exchange traded commodities (ETCs) such as iShares Physical Gold ETC (SGLN) tend to have less correlation to equities than funds that invest in gold miners. But the latter can make better returns when the gold price is rising.

With property, exposure to physical buildings is also likely to have greater diversification benefits than shares in property companies in the long run – despite what recent metrics suggest.

Daily dealing open-ended bricks-and-mortar property funds have had to suspend trading on a number of occasions because they have not been able to sell their assets quickly enough to meet investor redemptions. So investment trusts or real estate investment trusts may be a better way to get exposure to an illiquid asset such as property. And although Ediston Property Investment Company (EPIC) and BMO Commercial Property Trust (BCPT) have been hit by uncertainty in the sector, they could do well in the long term. Analysts argue, for example, that Ediston has endured share price falls because of concerns about the retail sector. However, this trust might prove resilient because it focuses on retail warehouses rather than high-street shop units.

Source: FE, 18 February 2020