Is diversification dead?

Anthony Rayner, manager of Miton’s multi-asset fund range, considers how to structure a truly diversified multi asset portfolio amidst high costs and valuations while preserving capital.

Is diversification dead?

The number one question we are asked by clients is how to structure a truly diversified multi asset portfolio when bonds are so expensive. This is closely followed by concerns about high valuations across financial markets in general. Both of these points relate directly to concerns about preserving capital.

The hierarchy of risk in multi asset funds tends to be dominated by equity risk. This is currently the case, so it’s right to consider how to diversify that. What’s certain is that it won’t always be the same asset class that’s the best diversifier, as the behaviour of asset classes and the way they behave in relation to each other changes all the time.

For example long-dated developed economy government bonds, the ‘textbook safe haven’, are very expensive compared to history and, with yields so compressed, provide a very limited potential buffer in the event of a risk-off scenario. In addition, with interest rates close to multi-year lows and with a large proportion of government bonds owned by central banks, it’s not hard to see the headwinds that bonds face.

One of the advantages of managing multi asset funds is the range of levers we can employ, but that also means we can pick our battles. In bonds, we can avoid the very low yielding Eurozone government and corporate bonds and the longer duration area of the bond market more generally, which is more sensitive to interest rate rises. Instead, we have material exposure to good quality short-dated US corporate bonds.

What else might help to diversify multi asset funds? This depends on what scenario we face. It’s likely that asset classes will behave quite differently if, say, stronger growth pushes up inflation and central banks have to raise rates versus a scenario where cyclical growth continues to soften and disinflationary pressures return. We can’t know the future, and there are many more scenarios than this, for example in a severe risk-off event it might be that gold or cash is the ultimate diversifier.

Looking at the data in front of us now, our base case remains for growth to continue to be decent and central banks to raise rates opportunistically. In this scenario, good diversifiers to equity would likely be short-dated investment grade corporate bonds while, within equity, we have a number of unrelated themes to help to diversify risk.

We have exposure to technology healthcare, European banks and the Indian consumer, and would expect little obvious reason for these exposures to have a particularly close relationship. In addition, we have some equity which should do well in a strong growth environment, such as financials and materials, and equities which should do well in an environment of lower growth, such as technology disrupters.

We also ensure that these broadly unrelated investment views are scaled appropriately, so that total portfolio risk is not dominated by any of them. This includes trimming the winners, so that risk doesn’t become too concentrated.

More generally, while this bull run and economic cycle are extended compared to history, there’s no point in fighting ghosts. Yes, valuations are high but history has shown them to be a poor indicator of the timing of market corrections.

We don’t believe diversification is dead: bonds are stretched but there are many different ways to diversify risk in multi-asset portfolios. In the meantime, we remain exposed to the dominant trends but remain vigilant, with liquid portfolios so that we can ensure our funds are properly diversified, whatever the environment.

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