Diversification myths exposed
During times of crisis, markets seize up and the majority of assets – even so-called safe-haven ones – perform the same way: badly.
By Mark Smith, Reporter, FE Trustnet
Wednesday June 13, 2012
A traditional multi-asset portfolio does not provide an adequate level of diversification, according to professional investors.
Diversification is one of the central pillars of investment theory but the basic premise of not putting all your eggs in one basket is becoming more difficult given the various macro headwinds that are plaguing globalised markets.
Bestinvest’s Adrian Lowcock says that the risk-on/risk-off trade that has dogged markets since the last financial crisis has caused all asset classes to become increasingly interconnected.
"High correlation is a sign of financial crisis – when people get spooked, the markets seize up and everyone opts for cash. We saw this in 2008 when everything apart from gilts fell off a cliff initially," he said.
Performance of sectors vs index in 2008
Source: FE Analytics
"We’re still seeing this due to all the uncertainty surrounding political will. One minute everything is on the up, but then as soon as there is a little bit of fear there’s a flock to safe havens."
The traditional multi-asset portfolio, which holds a mixture of bonds and equities, is likely to perform similarly if Greece exits the euro or if the global economy fails to climb the ladder of recovery.
Traditional safe havens such as UK, German and US government debt are presently offering little protection because record low yields and high inflation mean that investors holding gilts, Treasuries or Bunds are essentially locking in negative returns.
At the other end of the spectrum Tim Cockerill, head of collectives research at Rowan Dartington, says that high-yield bonds also offer little protection on the downside.
"The link between high yield bonds and equities has always been underlying but the extent of the correlation in times of trouble has become more intense. A significant sell-off in the equity market will also see the bond market fall."
Even emerging market investments, which have been the major drivers of returns in recent years, are becoming more closely correlated to developed equity markets as countries such as Brazil, China and Russia become more reliant on trade from the West to prop up their export-led economies.
With mainstream asset classes providing little protection against the world’s risks, investors may be tempted to look at gold, the traditional hedge against stock market catastrophes.
The commodity was one of the big winners from 2008, gaining more than 46 per cent.
However, Mark Wright, portfolio manager of the CF Midas Balanced Growth
fund, says that recent market swings have made the precious metal behave erratically.
"Gold has become a risk-on commodity
the link to equity markets is clear to see. That is the main reason it has been so oversold lately," he said.
"It’s certainly true that asset classes have become more correlated in recent years. It is becoming harder and harder to diversify."
Furthermore, investors buying gold funds such as BlackRock Gold & General
or Smith & Williamson Global Gold & Resources
as a hedge against market falls have found that, despite the gold price's extended run, miners of the precious metal have suffered along with everyone else.
The average gold fund is down 14.49 per cent in the year-to-date compared with a gain of 0.68 per cent from the FTSE All Share.
Wright says the key to spreading risk is to look further afield.
"We’re happy to hold virtually anything in the pursuit of diversification," he explained. "We’re finding plenty of instruments that are lowly correlated to the FTSE. You just need to know where to look and be sure what you are buying into."
In the next article in this week’s Diversification Special, FE Trustnet explains how to gain access to uncorrelated assets.