Achieving diversification from a global equity portfolio

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”. 

 david.thorpe@ft.com