Achieving diversification as the investment landscape evolves

Consensus appears to be that markets are in ‘melt up’ mode as artificially low interest rates and lack of yield elsewhere help to assuage any concerns about the economic recovery and rising inflation. It is particularly at such times that investors should ensure portfolios are adequately diversified relative to risk profiles in order to protect against setbacks. Yet, while acknowledging individual circumstances, there is little consensus as to how this should be best achieved – particularly as a new market regime unfolds. The good news is that sound asset allocation can still produce good risk-adjusted returns.

The theory

Diversification is an important investment discipline which is sometimes overlooked until it is too late. When starting an investment journey, it makes sense to focus on equities – they have performed better than most other assets over the long-term. But as time passes investors should increasingly be looking to protect past gains, particularly if financial goals are approaching, for market corrections can be cruel in their timing and devastating in their effect.

The discipline involves reducing portfolio risk by reducing exposure to equities in favour of other 'uncorrelated' assets – assets that tend not to move in the same direction as equities over the same period. While few investments will entirely escape a major equity market correction, adequate diversification will help to reduce losses. These other assets can also help to achieve a high and growing income, which investors typically seek as their journey progresses – income being an increasingly important contributor to total return over time.

There are no fixed rules as to the pace and extent of diversification. An investor's income requirement, investment risk profile and financial objectives are key factors. Perhaps the most important factor is the extent to which a portfolio accounts for overall wealth – a portfolio representing just 5 per cent can afford to take on more risk than one representing 95 per cent, but again individual circumstances are paramount.

The practice

By way of illustration as to the portfolios’ approach, five of the nine real investment trust portfolios managed on the website www.johnbaronportfolios.co.uk pursue an investment journey which sees them increasingly embrace other assets over time as they seek greater diversification. The Growth and Income portfolios covered in this column are part of this five portfolio journey – where they have been called Summer and Autumn since their inception at the beginning of 2009. The table below, taken from the website’s open Diversification page, highlights how the journey unfolds.

Investors should remember that the very concept will, to varying degrees, see the various assets perform differently even though globalisation has contributed to a rise in correlation between certain asset classes. Investors should therefore retain an element of perspective regarding the market’s individual view of the various components, for the next crisis is unlikely to be a repeat of the last.

Key holdings held by the various portfolios include the more traditional alternative assets of bonds, infrastructure, specialist debt, renewable energy and commercial property – CQS New City Yield (NCYF), HICL Infrastructure (HICL), GCP Asset Backed Income Fund (GABI), JLEN Environmental Assets Group (JLEN) and Standard Life Property Income (SLI) being examples. Each has played their role over the years in helping the portfolios to diversify while outperforming their benchmarks, and will continue to do so.

But such ‘conventional’ diversification in isolation may be less effective going forward. Various factors suggest additional nuances are required. Markets have acclimatised in recent years to low economic growth and subdued inflation – as such, conventional bonds and equity ‘growth’ investing have dominated investment strategies. As highlighted in previous pieces, a better balance is now required as governments attempt to engineer strong economic growth and the risk rises of a meaningful increase in inflation. Portfolios need to recognise this transition or they will struggle to outperform.

For example, within our portfolios’ equity exposure, a better balance has been introduced between growth and value – the former having previously dominated by some margin. This is prudent when seeking diversification in general, but it has also better enabled those portfolios progressing along the investment journey to embrace higher-yielding holdings within their declining equity exposure – the website’s Winter portfolio presently yielding 4.1 per cent.

Meanwhile, for reasons first highlighted in the column ‘Of testing markets and troublesome KIDs’ (11 September 2020), rising inflation has also been factored into portfolio construction. This at least in part accounts for the increased exposure to index-linked gilts, gold and commodities, with key holdings being iShares Index Linked Gilts ETF (INXG), WisdomTree Physical Gold £ ETF (PHGP) and BlackRock World Mining Trust (BRWM) – ETFs being used where no direct investment trust equivalent exists. The increased exposure to HICL also factors in its earnings’ high correlation (0.8) to inflation.

But something more is still needed. We need again to question the ability of governments and financial institutions to assess risk. Covid-19 was not a ‘black swan’. A major Government assessment only a few years ago, and many esteemed epidemiologists over recent years, identified a pandemic as a most likely danger. And yet the large financial institutions had not factored this at all into their assessments of market risk – once again reminding us of the folly of forecasting.

Greater portfolio resilience will be required especially as the transition to the new market paradigm unfolds. Unconventional protections will need to be better embraced including derivatives that hedge against market setbacks, such as VIX calls which benefit from volatility and equity put options which benefit from market falls. This is one reason the more defensive portfolios have increased their exposure to capital preservation investment trusts – namely Personal Assets Trust (PNL), Capital Gearing Trust (CGT) and Ruffer Investment Company (RICA).

Portfolio performance

The good news is that adept diversification can still produce sound returns. For example, despite the extent of diversification, the Winter portfolio has outperformed the FTSE All-Share index since its inception on 1 January 2014 – latest figures to 31 August 2021 showing it has produced a total return (including dividends) of 63.9 per cent compared with 50.5 per cent for the index. Although the portfolio has tended to modestly trail rising markets, it has fallen less when markets have retreated, and this cumulatively has produced superior returns.

Likewise, the website’s Dividend portfolio has outperformed for similar reasons. It seeks a high and growing income and presently yields 5.0 per cent. Nearly half of its exposure is committed to assets other than equities. It has produced a total return of 62.4 per cent since its inception in April 2016 compared to 47.9 per cent for the FTSE All-Share.

Such a portfolio characteristic can be very important to certain investors who prefer lower volatility to better performance, and may best harness the many advantages of investment trusts given greater volatility is usually the price to be paid for their superior performance.

Words: 1,115 (excluding diversification and performance tables)

Portfolio performance

                                                Growth                  Income

1 Jan 2009 – 11 Sep 2021

Portfolio (%)                                         453.9                      300.6

Benchmark (%)*                                  216.9                      160.0

Calendar YTD (to 11 Sep 2021)

Portfolio (%)                                         12.3                        8.8

Benchmark (%)*                                  11.5                        8.0

Yield (%)                                                2.4                          3.2

* The MSCI PIMFA Growth and Income benchmarks are cited (total return)