For us, the most important driver of outperformance is sensible portfolio construction and that’s why it’s at the centre of everything we do. But even here, concepts like diversification mean different things to different people.
Most agree that diversification is about reducing investment risk by, cliché that it is, not putting all your eggs in the same basket. But just because it’s a different basket, doesn’t mean it’s not exposed to a very similar type of risk.
For example, conventional wisdom suggests that having a broad exposure across different asset classes is one of the best ways of achieving a diversified portfolio. However, emerging markets and commodities, for example, whilst they are very different asset classes, are actually very exposed to a similar risk factor, namely global demand.
In order to properly understand their different biases, portfolios can be sliced and diced in many different ways. For example, an understanding of asset class exposure would benefit from being looked at in the context of a portfolio’s currency, duration, yield, market cap and sector exposures.
Taking a step back, a lot of risk analysis is built around the concept of a risk-free rate, typically a 10-year developed-economy government bond yield.
Traditionally, this is used as an anchor around which a portfolio can be built. The assumptions underpinning this choice revolve around the idea that risk-free assets have a lower return than risk assets, that there is no difference between anticipated and actual return for risk-free assets and that there is very little correlation between risk-free and risk assets.
However, as we have seen in recent years, none of these assumptions have held and, with debt levels of many economies at extreme levels, government bonds seem an even stranger choice for an investor wanting a risk-free asset, especially if it’s to be used as a reference point for the rest of the portfolio.
Some may argue that it has been a very unusual period and, whilst that’s true, it’s never helpful to consider risk as a constant. For example, government bonds tend to have a low correlation with equities but there are extended periods when this is not the case. Similarly, gold is often considered a good hedge against equities but in 2009 and 2010, they both rose materially. Environments and relationships change.
There have been periods when risk, per se, has been less of a focus, for example before the great financial crisis, during the ‘goldilocks period’ of strong growth and low inflation.
However, the current environment is characterised by economies and monetary policies that are diverging, and so policy risk has risen. Geo-political risk, meanwhile, seems to be edging towards centre stage, while an increasing amount of perceived ‘constants’, such as a high and stable oil price and the Swiss franc peg, are breaking down.
Certainly at the moment, currencies seem to be acting as the main ‘shock absorber’ to market events. We avoid assuming that this will continue to be the case, just as we avoid forecasting risk, as it feels a fairly endless task, with limited evidence of success.
Instead we concentrate our energies on understanding the current risk environment and trying to ensure that our portfolios are exposed to a range of broadly unrelated risk factors.
Anthony Rayner and David Jane (pictured on page one) are from the Miton multi-asset team. The views expressed above are their own and should not be taken as investment advice.