Institutional investors have long recognised that diversification is an essential part of investing for the long term. Many may believe that their portfolios are adequately diversified, even if they lack certain specialised asset classes. After all, correlation between the US stocks that form the S&P 500 Index has fallen to its lowest level in more than a decade.
Chart 1: Correlation between stocks in the S&P 500 Index
Source: Bloomberg, Aberdeen Standard Investments, February 2018.
In addition, traditional balanced portfolios of 60% stock and 40% bonds haven't experienced a drawdown of more than 10% since the global financial crisis (Chart 2). It's no wonder many investors have become comfortable with their current level of diversification.
Chart 2: 60/40 Real Return
Source: Aberdeen Standard Investments calculations based on data from Robert Shiller
(www.econ.yale.edu/~shiller/data) as of December 31, 2017
The danger is that they fail to see beyond the here and now to assess potential future risks and how to address them. But it is vital that investors face these challenges and make thoughtful decisions regarding their long-term investments. The recent market volatility serves as a reminder that the calm market environment we have become used to may not last forever.
All around us, the world is changing. Emerging markets are gaining a larger portion of the world's wealth and market capitalisation. On the other hand, developed markets have recently faced more uncertainty as they grapple with changing political landscapes and central banks' plans to eventually unwind the accommodative monetary policies that have been in place for nearly a decade. At the same time, new asset classes and market segments are being introduced, with some having the potential to enhance portfolio diversification and lower total portfolio risk. To adapt to these changes, investors need to take a fresh look at deepening their portfolio diversification.
Not only must investors re-examine their current allocations, but they must also challenge their ingrained notions of what it means to be diversified. In this paper, we look at both traditional and new ways to measure risk in portfolios. We also consider where investors should seek f new opportunities in order to improve portfolio diversification.
For decades, many investors felt that a "balanced" portfolio consisting of 60% domestic stocks and 40% domestic bonds provided adequate diversification and compelling risk-adjusted returns. And this seemed true while investors benefited from double-digit bond yields and stock market returns. But examining a US-based proxy for this combination, consisting of 60% S&P 500 Index and 40% Bloomberg Barclays U.S. Aggregate Bond Index, makes it clear that return expectations for this type of portfolio have changed dramatically. The S&P 500 Index returned 18.2% on average during the 1980s and 19.0% on average in the 1990s; expected three-year returns for US equities are now projected to be around 4.4%, according to Aberdeen Standard Investments' long-term outlook. Likewise, the Bloomberg Barclays US Aggregate Bond Index returned 12.8% on average during the 1980s and 7.9% on average in the 1990s, but Aberdeen Standard Investments now expects that three-year returns for US investment-grade bonds will be around 2.3%. Expectations for bond returns are more problematic than those of stock returns since all three components of US yields are well below their pre-crisis levels.
For many investors, these asset classes and their low expected returns will not be adequate to help them achieve their return objectives. Investors searching for true diversification among their investments need to venture out beyond the 60/40 portfolio of traditional assets. They need to find investments that not only have greater return potential, but can also respond to changing market conditions, including periods when equity markets experience a downturn.
Measuring portfolio diversification relies on identifying the sources of risk in the portfolio. Many investors emphasise correlation during their evaluation, believing that if the correlation of the investments in the portfolio to one another is low, this implies greater diversification. But putting too much emphasis on correlation can also be misleading. Here are three examples that show why looking only at asset class correlations is insufficient for assessing whether or not a portfolio is truly diversified:
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Tail behaviour. Tail behaviour refers to how two markets behave during an extreme (or tail) time period or event. One tail-dependent relationship that correlation fails to capture is that between equities and investment grade corporate bonds. During times of market stress and volatility, these two asset classes tend to move in close alignment. But over the last 10 years, the correlation between stocks and corporate bonds showed only a slight increase, even during the most turbulent months of the global financial crisis. While these two asset classes had similar performance patterns, correlation failed to capture this connection.
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Regime shifts. As the Eurozone dealt with its debt crisis over the past 10 years, correlations between the euro and US dollar fluctuated dramatically, as shown in Chart 3 below. For instance, when looking at one-year rolling periods, correlation swung between a low of -0.63 in May 2010 (marking the worst of the Eurozone crisis) and a peak of 0.59 in February 2015 (coinciding with quantitative easing). In both cases, there were unique, persistent market drivers influencing correlation over the timeframe.
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Outlier events. Investors seek consistent and practical methods to evaluate correlations between their portfolio exposures. However, the degree to which an individual historical event may destabilise correlation figures can be surprising. Chart 3 shows the impact of Switzerland's abrupt and chaotic removal of its three-year-old currency linkage with the euro in January 2015. This rocked financial markets, with the Swiss franc soaring over 20% versus other currencies, while Swiss equities plummeted. This had a very dramatic effect on correlations.
Chart 3: Historic correlation of USD/EUR currencies with European equities
Source: Bloomberg as of June 30, 2017.
While correlation is useful, such a backward-looking measure cannot provide a comprehensive view of portfolio risk. This was certainly the case during an extreme event like the global financial crisis. Investors who focus solely on historical information, in isolation from other factors, will miss the bigger picture. Instead, they need to consider other complementary methods to arrive at a more nuanced analysis of their portfolios. Forward-looking measures can help provide a more holistic view of portfolio risk.
The use of forward-looking techniques such as scenario analysis can help assess a portfolio's behaviour under various potential stresses. Investors must consider what method would work best for their particular portfolio. For example, adding or subtracting 100 basis points (bps) to bond yields to determine what return outcomes might be expected for the whole portfolio is a simple approach to evaluating possible future scenarios. However, this method wouldn't be sufficient for a multi-asset portfolio, as it fails to allow for the interconnectedness of asset classes or changes to those connections during times of stress. On the other hand, developing complex multi-regime and "fat-tailed"1 distribution models may provide more detail, but these models can be extremely complex.
Scenario analysis that combines the opinions and judgment of experts with quantitatively determined relationships between market risk factors will create more realistic scenarios. In this way, we can determine the expected effects on our portfolios of an unforeseen event in a rational manner that does not simply assume that history will repeat itself.
First, investors must consider possible, but plausible extreme future events - whether economic, political, environmental, societal or technological. Examples include events like a China crisis, political risks in Europe or the effects of stagflation. Experts' views can help identify the key factors and a range of potential responses, focusing on markets with a direct causal link to the extreme event under consideration. These key factor market moves can be combined with market simulations in a manner that weights the simulations to capture the fat-tailed nature of the outcome. This results in a range of possibilities under a particular extreme event, rather than at a single point in time. Using this method, investors can see how well the strategy weathered the projected stress scenario in comparison with the relevant asset classes.
The global economy has entered into a period of lower returns for the foreseeable future. As emerging markets have matured, growth has begun to slow down. Meanwhile, developed markets have experienced persistently low interest rates for nearly a decade, and although the monetary environment has gradually begun to tighten, rates remain near historical lows. These are the realities investors must face as they search for attractive returns.
There are many possibilities for investors seeking better diversification in their portfolios, and they span a wide spectrum of risk and return objectives. While a more conservative investor might lean toward multi-asset strategies as an alternative to a core stock/bond portfolio, investors with a higher tolerance for risk might prefer investing directly in emerging markets or alternative asset classes. Below we examine each of these opportunities.
At its most basic, a multi-asset strategy is one that spreads investments across different asset classes. However, in contrast to the traditional 60/40 balanced portfolio described above, the multi-asset category today includes a diverse and evolving collection of investment approaches. Many multi-asset strategies.
Some multi-asset managers may use positions like relative value strategies that allow them to express a view on the performance of one market compared to another. By doing so, they can achieve positive returns even if markets are falling as long as their preferred market outperforms. These diversifying positions can be used as a substitute for a traditional "core" portfolio of stocks and bonds or overlaid on a growth-oriented portfolio to reduce volatility and enhance diversification. Additionally, they can form the core of an absolute return approach.
Absolute return strategies seek to deliver a specific outcome; for example, an investor may seek to deliver returns in line with the long-term expectation from equities (or the equity risk premium) over much shorter timeframes (i.e. three years), with considerably less volatility than just investing in equities. For these investors, an allocation to a highly liquid and accessible absolute return investment may give more flexibility to protect against downside risks, while also providing a potential source of funding for less liquid investment opportunities. Absolute return strategies can also act as alternative to investing in bonds.
Although emerging economies continue to grow and modernise, investors' attitudes toward them are slow to change, often resulting in an underweight allocation to the region. In many cases, misplaced concerns about political and financial instability may make investors reluctant to increase their exposure to emerging markets, or to diversify within the asset class.
It is time to rethink these assumptions. Many emerging nations are beginning to adopt business-friendly reforms while paying down their debts and fighting inflation. Not only do emerging markets continue to experience faster growth than developed markets, but their exposure to different sources of return also provides opportunities to enhance diversification. Here are some of the opportunities institutional investors should consider within emerging markets:
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Frontier equity. Frontier markets are a subset of emerging markets. Typically, they are small, lower-income countries, with a nascent level of development yet generally high gross domestic product (GDP) growth rates. But this isn't the whole story. Many of these economies boast thriving private enterprises and a high level of entrepreneurship. Some frontier nations have transformed themselves over the past two decades, with progress on several fronts: literacy, access to credit, a communications revolution and improved public sector accountability. . These advances have elevated the sustainable growth rate for many frontier countries while helping reduce risks. Local exchange-listed companies are among the greatest beneficiaries of these developments. Additionally, valuations are attractive relative to developed markets in particular, as shown in Chart 4 below.
Chart 4: Trailing price-to-book ratios (MSCI), regions
Source: Ministry of Finance, 31 Dec 17. For illustrative purposes only
Many frontier markets have little in common with each other. The MSCI Frontier Markets Index has significant concentrations in terms of countries and sectors; several highly populous yet low-income nations are dwarfed by small and wealthy ones due to the relative size of their equity markets. Investors in frontier markets should consider an active approach to benefit from the variety of opportunities that exist beyond the confines of a benchmark.
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Emerging-market local currency debt. Opportunities in emerging-market debt look attractive relative to those in developed markets because of their idiosyncratic characteristics and potential for adding diversification to portfolios of developed-market debt. A weaker US dollar has helped support emerging-market currencies.
Emerging-markets local currency bonds have become appropriate for a wider range of investors. This trend is supported by improvements in valuation and liquidity. Historically, local banks and pension funds have been the main investors in local currency bonds. However, the institutional investor base has been growing both domestically and from overseas investors. This has provided impetus for further development of the market. A further easing of foreign investors' access to local markets will also help.
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Emerging-market corporate bonds. Emerging-market corporate bonds can complement to a portfolio that already includes investment-grade and high-yield bonds. While yields are slightly lower than US high-yield bonds and duration is slightly higher, emerging-market corporate bonds have better credit quality on average than high-yield bonds, with the largest portion concentrated in the BBB credit rating tier. Furthermore, emerging-market corporates have a default rate of 1.5% on average, compared to a default rate of 3.7% for high-yield bonds. Accordingly, investors with an allocation to emerging-market corporates have the opportunity to generate better returns without taking on significantly more risk.
Emerging-market corporate bonds are denominated in US dollars, including both investment-grade and high yield bonds, and make up a substantial slice of the global fixed-income markets.
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Frontier bonds. Frontier-market bonds are a relatively new addition to the index world. There was no dedicated bond index until the introduction of the JP Morgan Next Generation Emerging Markets (NEXGEM) Index in December 2011. The NEXGEM now consists of 35 countries, defined as the smaller, less liquid emerging-market economies with less developed capital markets.
While access to international capital markets has improved in recent years, frontier markets remain a small part of the overall emerging market universe. Issue sizes of up to US$1 billion, along with limited issuance, ensures these new issues are easily absorbed by the market, however. Such issues are typically associated with higher yields, enhancing their attraction in a low interest rate environment.
Chart 5: Comparing yields across emerging and frontier bonds
Source: JP Morgan, 28 Feb 18.
EM Local Currency Sovereign = GBI-EM Global Diversified,
EM Hard Currency = EMBI Global Diversified,
EM Hard Currency Corporates = CEMBI Broad Diversified,
Frontier Markets = NEXGEM,
US High Yield = JPM HY.
Indexes are unmanaged and have been provided for comparison purposes only. No fees or expenses are reflected. Individuals cannot invest directly in an index
Figures may not add due to rounding
For illustrative purposes only
Alternative strategies, particularly real assets and infrastructure, typically add different risk exposures and provide a way to diversify portfolios consisting of traditional asset classes.
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Real assets. This asset class typically has a longer time horizon and differentiated return streams relative to traditional asset classes.
Real assets include oil and gas interests, with underlying owners retaining a percentage of the regular cash flows; timberland properties, which provide annual cash flow; and cash-generating farmland. The return from real-asset investing comprises both a return from the movement in the commodity price and an income return from skilful operational management of the asset itself. As the recent history of the US farmland sector shows, it is possible for these assets to deliver positive returns even when commodity prices are falling.
Assets under management in this sector have grown over time, particularly within the energy sub-strategy. This has been partly driven by the shale oil and gas revolution that began in the mid-2000s. Capital was attracted to the sub-sector in order to release cash flows from assets that were previously not producing returns.
Chart 6: Global natural resources assets under management
Source: Aberdeen Standard Investments, Preqin, October 2017.
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Infrastructure. Infrastructure investing has become more popular in recent years as a result of increased investor familiarity with the strategy and the continued search for yield. In addition to providing diversification within a portfolio of traditional assets, infrastructure assets can potentially offer both sizeable yield and protection during a period of rising inflation. Because of their extensive time horizons due to long-term government-backed contracts and subsidies, cash flows are relatively stable and infrastructure investments are relatively insensitive to changes in the economy.
Infrastructure covers a broad range of categories, including regulated assets such as electrical, water and wastewater systems; transportation assets such as roads, bridges, airports and seaports; communication assets such as broadcast towers, wireless towers, cable systems and satellite networks; and social assets such as schools and hospitals. Each of these investments will differ in terms of time horizon and risk-reward profiles as shown in the chart below.
Chart 7: Infrastructure investments comparison (%)
Source: Aberdeen Standard Investments, October 2017. Note: Risk increases from left to right. Returns provided are not intended to reflect the returns of any particular Aberdeen product. For illustrative purposes only and provides no guarantee of future results.
The construction and operation of complex infrastructure projects comes with a range of risks, including construction completion risk and operating risk. Often, there are also political and reputational risks due to the national economic importance of the assets. Because of these complexities, as well as the competitive pricing of projects, investors are best served in seeking out the most experienced investment managers in this space when allocating capital.
These alternative strategies may not be suitable for, or available to, all types of investors. This is due to high capital commitments, lock-up periods and often limited access to top-tier managers. But for investors that can remain invested over the long term, alternative asset classes have historically provided attractive returns and are less affected by public market conditions.
Conclusion
In a world of rapid change, no one can predict when the next bump in the road will occur. But while change is inevitable, preparedness paves the way for better possibilities. Investors who have prepared for change - by ensuring their investments are properly diversified - can confidently face whatever lies ahead.
1 Fat-tailed distributions occur when the distribution falls outside the normal bell-shaped curve. They arise when many events or values stray wide of the average, giving extreme high and low values. This makes the bell flatter and fat-tailed
2 The investments discussed herein may not be available or suitable for all investors unless the investor meets certain regulatory eligibility requirements.
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