Achieving better returns through true diversification

Often diversification is judged through the lens of investing in different asset classes. Portfolios invested across equities, bonds and property appear well diversified. However, in stressed market conditions we often see that these asset classes sell off all at the same time, because they are all linked to economic activity.

We believe diversification is best achieved when considered through multiple lenses, such as:

• Diversifying exposure away from corporate balance sheets to consumers and governments
• Accessing more diversified sources of return such as illiquidity, skill and insurance alongside the more traditional equity and credit ones
• Implementing through specialist managers that have deep expertise in their fields and are able to react nimbly to changing market conditions

A sign of a truly well diversified portfolio is when each element is delivering returns at different times.

Is diversification still important?

As people come to terms with the impact that recent market volatility has had on their portfolios it is tempting to think that the case for diversification has diminished. However, it is worth noting that the S&P 500 is back at the level it was just 5 months ago and there is still a significant amount of economic uncertainty ahead of us.

In simplistic terms we see that there are three broad plausible economic scenarios from here, which help us understand the range of possible impacts of COVID-19 on economic, business and financial market conditions in 2020/21. These are:

1. A global economic recovery in Q3
2. An extended global recession
3. A wide-scale credit squeeze and defaults

Unless you put 100% probability on the first scenario (and believe that this will lead to a very sharp V-shaped recovery that we have not seen in other such bear markets) and 0% probability on the second two scenarios, it makes sense to increase diversity from here.

Indeed, it is worth remembering that a diversified portfolio would also likely do well in the first scenario, and it may well be asset classes outside of equities that do the best.

Does volatility matter?

We believe that managing volatility, whilst still generating returns is an increasingly important objective for pension schemes.

• Firstly, it’s one less thing for trustees to have to worry about; this latest crisis is not just a financial one and we are all having to deal with many challenges, both personal and professional.
• Secondly, volatility does matter. Many pension schemes are regularly selling assets to meet benefit outgoings and avoiding having to crystallise significant losses is highly desirable.
• Thirdly, having strong downside protection really changes the way the trustee boards and fund manager approach decision making.