Limiting risk and boosting returns

01 September, 2006

Benefits of diversification

When constructing a portfolio, two main challenges present themselves – picking the right asset classes and then picking the best managers to run those assets.

Choosing an asset allocation strategy can help protect you from downside risk as well as helping to ensure that you maximise the benefit from potential upside. Interestingly, diversification is one of the few elements in a portfolio that is also free.

A strong investor can optimise their approach using the diversification tool. The last few weeks have exposed how quickly the direction of the markets can change, and investors’ risk appetite with it. It is moments like these that highlight the importance of protecting your client’s assets by holding as diversified a portfolio as possible.

For example, while equities remain an attractive asset class with a return premium (over cash) of around 3 per cent per annum, they carry with them an annual volatility of 15 per cent, which can make your portfolio returns highly variable.

It therefore makes sense to branch out into asset classes that don’t all behave alike, but can provide similar levels of return expectation. This is indicated by the correlation. For instance, if you add North American equity to a UK equity portfolio, the correlation is relatively high at 0.74; they behave in almost the same way (complete correlation being 1.0).

Choose global high yield bonds instead (correlation of 0.36) and there is less likelihood of the two moving in sync and more likelihood of the combination working together to yield more robust returns.

Combining multiple asset classes with a low correlation to each other has the potential to result in a more efficient portfolio, limiting your total risk and providing better opportunity for positive returns.

Where else to invest

In addition to traditional equities and bonds, investment opportunities include:

1. Higher yielding fixed income strategies such as high yield or emerging market debt both have sufficiently attractive risk/return profiles and low correlations to equities.

2. A diversified exposure to hedge funds has the potential to offer a risk profile close to bonds but with marginally higher returns and a low correlation with traditional assets. They are also less interest-rate sensitive than bonds.

3. A passive exposure to commodities has delivered broadly similar risk and returns to equities over the past 35 years. Most valuable is the negative correlation between the two classes, which means that holding commodities should help smooth the long-term performance of your portfolio.

4. Currency is highly liquid and offers low correlation to traditional assets. It is also capital-efficient, allowing you to target higher returns without using up large portions of your assets. This in turn frees up your capital to diversify your portfolio further.

5. Private equity: many of the performance drivers of private equity are different to those of the quoted markets. Private equity managers with a large network of contacts have an informational advantage over other investors, can influence the company’s strategic direction, and longer lock-up times allow them to pursue long-term growth. There are challenges to investing in private equity but, like other alternative investments, its appeal lies in its role as a portfolio diversifier and an attractive source of potential returns.

Regulatory aid

With the advent of Ucits III, many of these asset classes are now available to investors, giving more opportunity than ever before to build an efficient portfolio which makes the most of the opportunities available. In today’s volatile investment markets, adding real diversity to portfolios will be a much greater part of future mainstream thinking.

Printer friendly version

E-mail this to a friend

Order reprint