Investors have to accept a greater level of risk, less liquidity or lower returns than they have done in the past given the high correlation between the major asset classes in the current market, according to Hawksmoor’s Richard Scott, who says he has to work harder than ever to achieve true portfolio diversification. 
Scott has real sympathy for investors in the current environment as due to huge amounts of central bank intervention such as six years of ultra-low interest rates and quantitative easing programmes, he says building a diversified portfolio has never been harder.
This is a point that is close to his heart as well given that his highly-rated PFS Hawksmoor Distribution and PFS Hawksmoor Vanbrugh funds are designed to be “one-stop-shops” for investors who want a core holding or need to outsource their asset allocation decisions.
“The investment environment we are in at the moment is certainly not typical of what we have seen during our careers. These are not normal times,” Scott (pictured) said.
The manager points out that investors face somewhat of a stumbling block as the old model of portfolio diversification, which has worked so well in the past, is no longer attractive and more importantly will no longer work.
He says this issue was perfectly summed up by star US investor Howard Marks, chairman of Oaktree Capital, who recently described the current environment as the “most perplexing world” he has ever seen.
“[Marks] thinks because of that downward march in real interest rates and extreme monetary policy that investors are left with one of three choices if they want to generate superior returns – you either have to accept greater risk than you have in the past, go into more illiquid investments than you maybe did in the past or you’ve simply got to accept lower returns.”
“I think a prudent sensible investor has got to engage with those three points because they sum up the investment environment.”
In his presentation, Scott included a graph put together by Societe Generale which highlighted the yield on a traditional balanced portfolio of 50 per cent equities, 40 per cent government bonds, 5 per cent corporate credit and 5 per cent cash over the past three decades.
Yield on a ‘balanced’ portfolio since 1986
Source: Societe Generale
“In this period that goes back to 1986, investors in this simple diversified portfolio of global assets will have seen the yield come down from just over 6 per cent to 2 per cent. That is very significant because that is a before charges figure and it means we have to hunt hard to find those areas that can provide above average levels of income,” Scott said.
He says the lack of income available from traditional asset classes has caused a major issue for investors.
“If you look at the performance of US government bonds and equities, for many years they were negatively correlated. This will have led many people to have a ‘diversified’ portfolio of equities and a buffer of government bonds – that’s fine if you look back in the past but it’s not going to achieve diversification for you in the future.”
His thoughts are echoed by Troy’s Sebastian Lyon, who heads up the ever-popular Personal Assets Trust.
“The threat is that you no longer have that protection of negative correlation between bonds and equities which you have had in the past. In fact, as we have seen in the past few days, when an asset class falls they all will,” Lyon told FE Trustnet last month.
According to FE Analytics, the correlation between the S&P 500 and the BofA ML US Treasury Index is just 0.07 over the past 10 years. However, that has ramped up to more than 0.40 year to date and this is clearly shown in the graph below.
Performance of indices in 2015
Source: FE Analytics
As a result, Scott has been upping his exposure to more esoteric funds over recent months in an attempt to counteract the increasing correlation between bonds and equities and to try and protect his investors.
“Interest rates have fallen to such low levels, which means that bonds and equities have become highly correlated so you now need to try harder to achieve diversification,” Scott said.
“That’s what we are trying to do and we are doing that by having a broader range of different assets and seeing how they work and achieve a decent return over time. For example, we are blending convertibles, we are using infrastructure debt and we are using asset backed securities.”
“Some of these fall into the camp of what Howard Marks was speaking about as they are areas where you have to accept a bit less liquidity to achieve a better return. Asset-backed securities and infrastructure debt are good examples of that.”
The funds he has buying to give his portfolios a greater level of diversification include the TwentyFour Income Investment Trust for his ABS exposure, the Polar Global Convertibles and RWC Global Convertibles funds and JP Morgan Global Convertibles Income Trust for his convertibles exposure, and GCP Infrastructure for access to infrastructure debt.
TwentyFour Income, which yields 5.2 per cent, holds 48 per cent in European residential mortgage-backed securities, 36 per cent in collateralised loan obligations and 5.41 per cent in commercial mortgage-backed securities.
While investors will no doubt be wary of such asset classes given their role during the financial crisis, the trust has performed strongly over recent years.
According to FE Analytics, it has outperformed both equities and bonds since its launch in March 2013 with returns 39.60 per cent but, more importantly in this instance, it has been negatively correlated to both those asset classes over that time.
Performance of trust versus sector and index
Source: FE Analytics
However, given that performance profile and its above average yield, its shares are currently trading on premium of 7 per cent.
It is a similar story with GCP Infrastructure, which has delivered equity-like returns over the past five years but with bond-like income characteristics due to the fact it invests in debt issued by UK infrastructure project companies and related or similar assets.
While the trust yields more than 6 per cent, investors are being asked to pay a premium of 12.63 per cent. However, Scott says this is an unfortunate reality of the current market.
“Yes, I realise the premiums are quite high, but I think the portfolios would be impossible to replicate without paying a decent premium to current NAVs, so not only are they supported by their high yields, but also by the imbedded value in the portfolios,” Scott explained.
The other area of the market Scott rates in this environment is convertibles funds, which invest in fixed income assets that can be converted into a predetermined amount of the company's equity at certain times during their life.
In a recent FE Trustnet article, Scott’s colleague Ben Conway explained why they are such a good fit in the current market.
“Convertibles are a great asset class, but one of the reasons we were attracted to them at this point in time is when you look at the valuation on convertible bonds as an asset class, relative to their history, they are actually very, very cheap which is quite rare for the current environment,” Conway said.
“It’s not an asset class a lot of investors look at, which is perhaps why you’ve got this slight inefficiency. However, apart from the fact that it is cheap, they allow you to participate in equity market upside. However, the nature of the asset class means they act like a bond if equity markets were to fall.
He added: “It’s a perfect instrument for how we are currently thinking.”
Performance of fund versus indices over 5yrs
Source: FE Analytics
While Davide Basile’s $1.8bn RWC Global Convertibles has underperformed bonds and equities over the past five years, it has been very lowly correlated to the iBoxx Sterling Corporates All Maturities Index and has had a maximum drawdown – which measures the most an investor would have lost if they bought and sold at the worst possible times – which is three times lower than that of the MSCI AC World index.
