Achieving diversification from a global equity portfolio
Photo: Suzy Hazelwood/Pexels
Photo: Suzy Hazelwood/Pexels
Achieving diversification can be a challenge even in ordinary times, but more recently advisers and fund managers have had to work harder, and more imaginatively, to find a truly balanced portfolio.
There have been several periods when bonds have correlated with equities, making it difficult for money managers to develop sustainable, long-term investments.
But there is enough diversity in a geographical sense to make it worthwhile to invest in foreign equities, although how one goes about that also requires a fair amount of skill.
This report, which is worth an indicative 30 minutes' CPD, outlines some ways to think about it.
The latest FTAdviser Despatches poll indicates advisers are being tempted to increase the allocation to equities in client portfolios, even as markets have fallen.
The poll, which was conducted online, found that 42 per cent of respondents intend to increase allocations to equities across all client portfolios, while a further 38 per cent intend to do so for the clients with a higher risk tolerance.
Only the remaining 19 per cent of respondents are averse to increasing allocations right now.
The poll was conducted between October 3 and October 18, and came during a period when the market was particularly cautious on equity outlook as a consequence of fading hope around the US Federal Reserve moderating its interest rate rises, while events in Ukraine offered scant comfort for any investor.
But while volatility has been very high, it may be that advisers who have clients with a very long-term time horizon are keen to see if they can pick up bargains in the current climate.
Diversification, says Tom Wildgoose, head of equity market investment at Nomura, is not really a numbers game.
He says: “In terms of global equities, once you have about 30 stocks, you have got about 95 per cent of the benefit that comes from diversification already, if they are chosen well.”
Instead he sees diversification as being around choosing stocks that are in different parts of the market.
Chris Elliott, co-manager of the Evenlode Global Equity Income fund, agrees that a concentrated portfolio can provide the right level of diversification.
He says: “As active managers, we believe that the best way to deliver risk adjusted returns for clients is through investing in a relatively concentrated group of high-quality companies. Since launch, Evenlode Global Equity has typically held between 30 and 35 businesses with high internal returns on invested capital and sustainable competitive advantages.
"Despite these positive attributes, each of these businesses still face a range of risks specific to the products they offer and the markets they participate in. We see diversification (through position sizing) as a means to manage these risk exposures. This risk management would rarely be achieved by replication of the market.
"Take, for instance, the S&P 500, where over 21 per cent of the weight of the market is contributed by five technology companies (Apple, Amazon, Alphabet, Microsoft and Tesla). These share significant risk exposures and often trade with significant correlation, so would not provide the smooth ride that we seek for our investors.”
The challenge for investors in 2022 has been that those who have built a portfolio primarily exposed to value stocks as protection against inflation will have enjoyed strong performance earlier in the year, but weakness more recently, as the cyclicality of many value stocks became less attractive amid concerns about the economic outlook.
Those who bought growth equities, on the basis that they may be more resilient to a growth shock, have seen heavy losses for most of the year, as tighter monetary policy pushes discount rates higher, reducing the value of future cash flows.
Mark Hargraves, global head of equities at Axa Investment Management, says all portfolios have a style bias whether the portfolio manager intends for that to be the case or not, and says trying to move between the styles in line with the market is “difficult”, and the focus instead should be on which style a particular client wants exposure to.
Richard Garland, portfolio manager at Berenberg, says the traditional value/growth diversification approach works most of the time, but not when there are “systemic” risks, or problems in economies, where investors are unsure about how to price the various scenarios that could occur.
He says that in such a climate, “there is a flight to quality”.
Stephen Anness, who runs the Invesco Select Trust Global Equity Income portfolio, acknowledges that there has been something of a flight to quality, but says the issue he has with it is that “the relative price of safety has risen this year”.
He cited healthcare, consumer staples and utility companies as traditional “safe” areas, but says the valuations have become sufficiently expensive that he has begun to reduce his exposure to that part of the market.
Anness says that instead, “we have been eyeing up housebuilders and carmakers. To buy them now would be a contrarian move, but, with yields of up to 7 per cent, these sectors are beginning to look enticing.
"If you have some companies on sensible valuations that are paying a dividend and still growing quickly, then a few out-of-favour companies on low valuations and paying a high income can be attractive – as long as you are confident of being paid.
"That is the crucial issue. Some of the housebuilders and carmakers I am looking at now should be able to sustain high dividends almost irrespective of what goes on in the world. Even if they deliver very little equity market return, their yields look attractive.
"And there is the possibility of equity growth too, if market sentiment changes. You might consider them insurance against surprisingly good news”.
Garland says the problem with stocks that might be viewed as defensive in nature is they tend to be sensitive to movements in bond yields. This is because when bond yields are very low, some investors allocate to defensive equities, particularly income-paying equities, instead.
But as bond yields rise, those investors return to their natural asset class in fixed income, and so the defensive equities sell off.
This means, says Garland, that in the current climate, “there is really no hiding place”.
Baylee Wakefield, multi-asset fund manager at Aviva Investors, says that “diversification is not static”, but also not necessarily intuitive.
Wakefield says an investor pursuing a very logical equity diversification strategy in 2022 would probably own lots of commodity stocks as a hedge against inflation, yet since the end of May 2022 these sectors of the global equity market have underperformed.
She says: “Correlations between and within asset classes change, meaning that frequent monitoring and adjustments to allocations are important to maintain diversification. During the pandemic, Nasdaq and the tech sector were a useful hiding place for investors worried about economic lockdown; but this year tech names have simply magnified the return challenges of the broader market."
Half the world away
Another consideration for investors is around the geographical or market exposure of an equity portfolio.
Hargreaves says two things matter here: the performance of the currency in which the stocks are listed, and the level of exposure a company has to the economy of the country in which it is listed.
In the UK for instance, companies such as HSBC and Shell are listed on the domestic market and earn the bulk of their revenues overseas. They also pay their dividends in dollars, meaning exposure to a UK-listed company is providing exposure to global business factors, and to the dollar.
This can also work at the fund level, as a UK fund, which is valued in sterling but owns US equities, will benefit from the strength of the currency.
Hargreaves cites European banks as the counter-example, as most of those have operations focused on their own economy, and so, although banks might be expected to benefit from higher interest rates, there is less diversification there than with many other banks.
He also cites the example of emerging markets, which have structural growth and might be expected to cope relatively well in the current climate as a result of the large weighting to commodity companies.
But he says emerging markets have underperformed this year as a result of the strength of the dollar. This means investors who might have wanted exposure away from developed equity markets, or from the consequences on US equity funds, will have found themselves exposed again to dollar strength, one of the predominant factors impacting returns across all asset classes this year.
Garland says that if one allocates based on regions, the level of diversification is actually quite low, as the correlation between regions in equity markets is around 0.66 (with 1 being complete correlation).
He says the only way to achieve diversification is to buy companies that may be able to grow structurally, and do not need to rely on the economic cycle.
Nalaka Da Silva, head of private market solutions at Abrdn, says the opportunities for diversification right now may come from investing in areas such as listed infrastructure or renewable energy assets, as the performance of those assets is not especially linked to the wider economy.
Fahad Hassan, chief investment officer at Albemarle Street Partners, says the way to understand equity portfolio diversification is to divide it by the various ways in which one can get a risk premium, and so generate a return greater than the market if done properly.
He identifies these as being the factors as discussed above, growth and value, plus momentum, and the liquidity risk premium which can be accessed by investing further down the market cap scale.
He says a diversified equity portfolio should have exposure to each of these, and as economic or market conditions change, the investor can dial-up or down the level of investment in each of those areas.
Peter Ewins, the long-serving manager of the Global Smaller Companies investment trust at Columbia Threadneedle, says he does not like going too far down the market cap scale as he feels the companies there are much less well known.
He says this has been a particular challenge this year as some of the sectors that performed well, such as in the oil sector, tend to be represented in the small cap universe predominantly by companies that have “iffy” assets, creating a scenario where the risk premium may not be sufficient to justify an investment.
His way of getting exposure to the structural trend is to buy the companies that supply the oil and gas producers, as he says this way he does not have to try to identify which among the myriad small cap oil and gas producers that are listed around the world will actually win.
Ewins also referenced the benefits of US exposure at a time of dollar strength.
His trust can invest anywhere globally, but right now is overweight the US market.
He says his trust is down 24 per cent in nominal terms, but when the impact of dollar strength is considered he is only down 7 per cent this year to date.
Ewins says the US “is a good place to be right now and for the long-term. It is a bit of a diversifier from the rest of the world because it does not have the energy problems of Europe, so the consumer is a bit stronger. The one area that I am cautious on in the US right now is the housing market, as higher interest rates will obviously have an effect there”.
Diversification is often touted as the only free lunch in finance. Just as well – many would be demanding refunds otherwise. This year equities and bonds have seen double-digit falls, making a mockery of the 60:40 portfolio and leaving investors with a sour taste in the mouth.
We have had a bull market in nearly every asset class for most of the past 40 years. And for the past 12 years especially our free lunch of diversification has been accompanied with free wine – in the form of quantitative easing. No-one complained about diversification not working when bonds and equities were rising in unison. Now it has stopped working, many investors are challenging the logic behind building a diversified portfolio.
In theory, diversification helps us deliver the same outcome for a client but with less volatility. The dollar rises when the pound sinks; bonds lift when equities fall. The movements are all counterbalanced. If you have a spread of assets.
This matters, because clients need liquidity. They need to translate investments into cash sometimes – to pay for houses, replace the car or fund retirement. If their needs for cash collide with a violent downward swing in the value of all their investments their adviser will take the blame.
Insufficient space is a welcome excuse for not offering a thesis on diversification, but here are some lessons I have learnt over the past 20 years.
Diversification is a complex science
Modern portfolio theory inspires us to believe that scientific rules can be applied to building efficiently diversified funds. Markowitz won a Nobel Prize for his ground-breaking paper on the subject in 1952. This underlines how complex the factors driving market movements are. Perfectly counterbalancing these impulses is good in theory, impossible to achieve consistently – if ever – in practice.
Successful diversification is harder at some points of the market cycle
We sometimes think of diversification as planting a garden for year-round colour. But gardens bloom better in spring and summer. You cannot fight that. When we hit the winter phase of a market cycle it is harder to make diversification work – even more so if it is winter everywhere. Consider country selection. It provides less alpha when global markets slump through a coordinated business cycle decline or a coordinated liquidity reduction. But when the global business cycle is de-synchronised and central banks move in opposite directions, making money from country selection and diversification becomes easier.
Diversification can impair investment performance
We all know this, but it is surprisingly easy to fall into the trap of diversifying for the sake of it – buying Rio Tinto and BHP or JP Morgan and Citigroup, even though both pairs of shares are largely driven by the same external market and economic forces. Be careful that diversification does not undermine sensible conviction.
Focus on 'different'
If you are going to diversify, look for something genuinely different. For instance, we are currently overweight in Japan, because it has lived in its own world to some degree for the past 15 years or more. It would benefit from some inflation, and the weak yen benefits its exporters. Australia and Israel look interesting, because each has commodities and relatively positive demographic characteristics.
The world changes
Remember, correlations are not set in stone. Returning to Japan – 20 years ago buying Japanese equities was tantamount to buying a levered steel stock. It was a cyclical bellwether of the global economy. China has now assumed that role, and Japan has become a much more defensive market. Historical correlations change, as many have learned this year to their cost.
Passive markets have influenced market behaviour, too. Because of ETFs, stocks attracting a certain label – tech, value, growth – can move quickly in the same direction if there is a stampede for the exit. How a company is perceived and labelled can influence its performance. You must monitor correlations and be dynamic.
Do not underestimate the impact of currency movements
Our dividend distribution is up dramatically this year, because we have successfully diversified our investors’ income streams away from sterling dividends. Sterling’s fall has softened the blow of falling markets for UK-based investors holding overseas assets. This diversification matters. I believe I am paid to help ensure investors’ money is in the right mix of currencies.
Don’t abandon diversification
There have been days when I have been glad to have had a diversified portfolio – when too much value exposure has hurt us but having more would have been too painful to contemplate. It is still important. But it should not drive all your decisions. The mistake people make is to see it as a target. The clients’ objectives are the target. Diversification is just a tool to help us achieve those objectives.
Jacob de Tusch-Lec is manager of the Artemis Global Income Fund
Photo: Suzy Hazelwood/Pexels
Photo: Suzy Hazelwood/Pexels