Why diversify when equity returns are so strong and volatility moderate?
Global equity markets have produced very strong annualised returns in the past 18 months - in excess of 20% - with volatility as low as 6%. This might lead investors to question the need to diversify their portfolios. But risk has not really disappeared (as recent corrections in equity markets served to remind us!) and the outlook for equities is not as attractive as the returns we have seen over the last few years.
Actually, even the recent strength in equity markets masks the variability of long-term performance. Look back a bit further in time. If you asked most people what the annualised total return from US equities (the S&P 500 Index) was from 2000 to December 2017, many might believe returns were the equivalent of cash plus 5% or even cash plus 7%... Well, they would be wrong. Returns between those dates annualise at just cash plus 3%! Equities can perform well for long periods of time, but they can also go through long periods of weakness. As such, past performance over a specific period is not a guide to other periods of past performance.
You wouldn’t start from here
So how might equity and bond markets perform over the next few years? There are no guarantees here, but one guide is to look at how expensive these assets are when you buy them. It seems that, the more expensive the starting point is for your investment, then the lower the expected return generated over the next 12 months, possibly for even longer. In equities, most measures suggest valuations are well above average and could even be close to historic highs. Interestingly, the same can also be said of bonds. In the case of bonds, longer-term returns relate closely to the yield at time of purchase. Today bond yields are close to historic lows – and that suggests the strong bond returns of the last 20 years are likely to be a thing of the past.
Structural challenges for investors for the longer-term
We also have to factor in the structural challenges for longer-term investors. These include demographics (the fall in working age population in the developed world), the fading impact of globalisation of trade, China’s economic adjustment to a slower growing economy. Meanwhile, a savings ‘glut’ driven by QE programmes and the baby boomer generation’s savings is making the search for yield challenging – and it is getting worse.
All-in-all, our strategists estimate that a typical ‘60% equity/40% bond’ portfolio could return 3% p.a. over the next 30 years – rather than the 7% p.a. return that it has delivered over the last 20 years.
Bridging through diversification
So what can we do? Many multi-asset managers try to be bolder in their market timing – both to smooth returns, but also to generate the extra performance that their investors seek. However, seeking to add consistent return in this way can be challenging and can also conflict with managing risk. We believe that a better starting point is to diversify your portfolio. Combining a greater range of return drivers means an attractive return should come through in a more consistent fashion. When there is a lower reliance on equities to deliver growth, for example, then the portfolio should be more resilient in the event of sharp falls in equity markets.
Identifying a range of opportunities – and their expected returns
If we reduce our allocation to equities and bonds, we need to add other sources of potential growth into the mix. One option would be to make greater use of the various asset classes that are accessible today to institutional and retail investors alike. These opportunities include higher yielding opportunities in credit - global loans, private debt and aircraft leasing, for example – or real assets, such as social infrastructure, renewable infrastructure and social housing as well as specialist opportunities such as insurance-linked securities, litigation finance and healthcare royalties. Genuine diversification can be achieved, helping to lower portfolio volatility and to provide more ways to generate growth and income. Notably, all these opportunities can be accessed today in a daily dealing format – enabling us to incorporate them in our multi-asset solutions.
Identify risks then invest to smooth the journey
Another option would be to use more traditional assets in a different way. For example, we can invest to profit from the differences between markets. We can also allocate to strategies where there is no expected long-term ‘risk premium’, but where responding to the dynamic and inefficient nature of markets to establish positions can offer attractive return opportunities. For example, holding the Japanese yen (a defensive currency) versus the Korean won (which is linked to global economic growth) can help mitigate the impact of falling equity prices; investing in US real yields can protect against the risk of future inflation; and investing in European bank shares relative to the European equity market as a whole offers the potential for positive performance if interest rates rise.
Different approaches to multi-asset
There are clear challenges ahead for traditional asset classes and for multi-asset solutions that rely on them. Thankfully, there are also more ways that we can help to diversify portfolios to bridge that gap. Over the years, we have independently developed two strategies to deliver this – one focused on diversification by asset class, the other offering diversification across strategies. Both, we believe, can deliver a compelling long-term return for our clients – genuine diversification for the difficulties ahead.