Has Covid-19 meant that the traditional ways of seeking diversification within an investment portfolio are outdated? 7IM’s Matthew Yeates suggests that a new way of thinking is needed for effective risk mitigation.
Diversification has shown time and time again to be the best way to protect against market falls, such as the ones we have seen over the past few months.
None of us expected Covid-19, nor did we expect the scale of the lockdowns enforced around the world. Building in resilience against these unknown events through diversification is a vital step at mitigating risks.
However, while we used to be able to simply rely on a mix of bonds and equities to achieve a relatively diverse portfolio, this is certainly no longer the case, and indeed no longer counts as true diversification in terms of properly spreading the risk in portfolios.
As markets change and evolve, diversification has become ever more important, but the routes towards this have become broader and more varied.
A new solution to an old problem
Traditionally, a balanced portfolio would include a mix of equities that would grow the pot, and bonds which would provide some security during market downturns. However, bonds failed to live up to their defensive role during the sell-off caused by the coronavirus. We would have expected these to rise when equities fall, providing some yield income to balance out the drop. This did not happen. The market movements over the past few months mean that most investors holding UK gilts are now receiving hardly any income at all. To make matters worse, some gilts now have negative rates, meaning that investors are actually in a position of paying the government to hold their bonds.
As a result, many bonds now look very unattractive for diversifying portfolios as they no longer provide the guaranteed protection they once did.
This means that investors should be looking for defensive options elsewhere, and in turn diversification itself now needs to take on a new meaning.
The case for alternative assets
We see alternative assets as a great way to fill the space which bonds once dominated. When choosing these assets, it is important to keep in mind that this pool of investments is vast, and investors should look to avoid illiquidity, high fees and becoming involved in an overly complex tangle of different restrictions.
An example of a good alternative asset would be global real estate investment trusts (REITs). These trusts offer exposure to the global real estate market which diversifies investments away from equities but also offers liquidity, ensuring investors don’t get tied up with the asset.
A further example would be the “event driven” strategy by Blackrock. Event driven strategies frequently come under the name of merger arbitrage strategies, focusing their investments in companies undergoing a process of mergers, either as a target or an acquirer. This strategy has the flexibility to invest across a mix of (mainly) equity-based opportunities arising from mergers and acquisition activity. There is a high opportunity for alpha in the space, with an associated insurance-like return for taking on merger risk. Even in the recent COVID period, merger deals continued to take place. Therefore investors could earn a return from simply being exposed to that risk regardless of the direction of broader equity markets. This more contractual return, on top of the alpha available, makes it a great option for portfolios of alternatives. The above strategy is led by Mark McKenna, who we see as a heavyweight in the space supported by a wide team, many of which have worked with Mark in the past.
In more quantitative or systematic strategies we also see a lot of opportunities. For example, we favour the use of a number of liquid alternative strategies, including commodities on a ‘long short’ basis. Through this, investors can utilise the benefits from secure long-term contracts and the often volatile nature of contracts coming to delivery in a matter of months. It also invests in liquid markets which means it is low cost to implement.
Such a strategy would have worked well when we saw oil prices drop dramatically earlier this year, by selling the stocks that had fallen the most.
Geography also plays an important role and needs to be included in any approach to diversification. This doesn’t just mean looking to international stock and bond markets – although these can be an important way to diversify your holdings – but also involves utilising tactics such as holding foreign currency. This works by providing a buffer that can protect against the often volatile turns the UK’s pound can take, as we saw in 2020. This is another sensible strategy which offers a high level of liquidity should any rebalancing be needed.
The past few months have shown that an over-reliance on bonds to defensively position a portfolio might not achieve the desired outcomes. Investors can achieve the same aims by instead increasing the scope of assets and strategies that make up the balance of a diversified portfolio. With the right strategy in place, alternatives can become a valuable source of diversification in a portfolio, one which can provide the same balance that bonds would have.
About Matthew Yeates
Matthew leads alternatives and quantitative research at 7IM and sits on their Investment Committee. He was the lead designer of 7IM’s Retirement Income Service (RIS). Matthew joined 7IM in 2014 from Brewin Dolphin where he worked as a Quantitative Analyst in Investment Research. He holds a degree in Economics from University College London and is both a Chartered Financial Analyst (CFA) charterholder and a Certified Financial Risk Manager. He was named in the Forbes 30 under 30 list for 2020 and was the youngest of Financial News’ rising stars of asset management in 2017.