When is diversification actually ‘diworsification’?

12th August 2015

Anthony Rayner, co-manager of Miton’s multi-asset fund range, comments on achieving investment diversification beyond simple asset allocation…

We recently highlighted the rationale behind our portfolios’ current positioning. We have no commodities, no emerging market bonds, minimal emerging market equity and, in terms of developed government bonds, very little overseas and only short dated gilts.

At first sight, this is quite a focused strategy for multi asset portfolios. Indeed, conventional wisdom suggests that a portfolio with exposure across a broad range of asset classes is the best way to sensibly diversify. In practice, this leads many investors to assume that long dated government bonds and commodities, for example, are always good diversifiers to equities.

We have always questioned this approach to portfolio construction and conclude that it’s too dogmatic. We do believe there will be periods when most asset classes will prove good diversifiers but the behaviour of every asset class changes over time and, therefore, so does the way they interact with other asset classes.

Instead, we try to ensure that our funds have exposure to a number of investment ideas that are as uncorrelated as possible. This should mean that we are well positioned to perform across a range of scenarios which, after all, is what diversification is meant to achieve.

The current environment is an excellent case in point, in that we have been concentrating our portfolios’ exposure in order to reduce risk. This sounds counter-intuitive, so we revert back to our trusted DNA system, which focuses on Data, Narrative and Affirmation.

Certainly, in terms of the Data, we are seeing the weakest growth momentum in emerging markets since the financial crisis, with four countries in recession, namely Brazil, Russia, Ukraine and Venezuela, and big question marks around heavyweight China’s growth.

At the same time, the US dollar has been front-running a hike in US rates, and commodity prices have been collapsing. Of course, many of these are related dynamics but the result has been fairly binary in that developed assets have performed much better than emerging.

The Narrative is fully behind the data but at some point there will be a levelling out and our DNA will encourage us that these assets have a role in our portfolio again, in part no doubt, to diversify our dominant risk, which is often equity beta. In the meantime, the Affirmation element has been giving us strong signals, through looking at the price momentum of asset classes. It was specifically the negative price momentum which was the nail in the coffin for our limited commodities exposure.

Over the last few weeks, we have sold our small gold position and our oil-economy bonds, namely Mexico, Peru and Norway, as it became clearer that there was another down leg in commodity prices.

Our base case remains for a low rate cycle, with equity opportunities in the Quantitative Easing (QE) economies of Japan and the Eurozone, and the strengthening economies of the UK and the US. We maintain a material weight to property and our bond exposure is dominated by short duration gilts and corporate bonds, with the latter at the high end of the quality spectrum. We also retain an elevated cash position, which might prove to be a decent diversifier.

We think actively managing risk is central to our role and this means active asset allocation too, even if it leads to periodic concentration in certain asset classes. Importantly though, we continue to have a number of investment views which we believe is a better way to achieve diversification, rather than through the constrained perspective of asset class weights.


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