Fidelity CIO: Thinking differently about diversification

By Andrew McCaffery, Global Chief Investment Officer
Henk-Jan Rikkerink, Global Head of Solutions and Multi Asset

Investors use diversification in an attempt to manage overall portfolio risk. When one asset class underperforms, others with weak or negative correlations should act as counterweights. But when the Covid-19 crisis hit, the correlations between different asset classes rose. This often happens during market panics, but this time, certain areas of expected uncorrelated returns didn’t offer quite as much protection as expected.

The traditional bond/equity mix often used to diversify portfolios may therefore have to evolve to encompass a broader range of assets, depending on individual risk preferences.

“In general, what you are often looking for in diversification is where you can get low or negative correlation to risk assets, in particular to equity exposure,” says Henk-Jan Rikkerink, Global Head of Solutions and Multi Asset.

Asset class correlations tightened or turned positive during the market rout because people were making investment decisions under pressure. And while some traditional correlations persisted during the panic, their magnitude was far smaller than in previous crashes.

For example, holding high quality government bonds as part of a typical 60/40 balanced portfolio offset some of the damage from equity and credit sell-offs, but not to the degree that may have been expected. This is because government bond valuations were extremely high going into this crisis. The Japanese yen - while volatile - offered a negative correlation to risk assets, and with a better magnitude, thanks to a lower starting valuation.

Alternative investments, meanwhile, saw different implied return patterns depending on their sub asset class. Many did correlate more highly with underlying equities and credit, and with a magnitude that had not been expected; for example, real estate has, unusually, been on the frontline of this crisis, with several sectors suffering from income challenges and capital value mark downs as many companies struggle to pay rent for shuttered premises.

As markets heal, correlations will typically weaken again. However, while traditional assets (like government bonds) continue to offer elements of diversification, with yields at all-time lows, it is unlikely to be of sufficient magnitude for investors to reduce risk as much as before, while also meeting their income and return needs. Not that is, unless the Federal Reserve pushes interest rates below zero. But that may pose broader difficulties for money markets and overall system ‘plumbing’.

Risk-mapping may need to be more granular

Instead, we believe investors will seek other types of uncorrelated return profiles. What they choose will depend on their core objectives and time horizon, and if the rewards available are commensurate with the risks taken.

Traditional risk measures tell us that equity and high yield bonds offer higher yields than government bonds, but with less certainty of capital return. Alternative investments or strategies can offer higher rates of income and return, but with lower liquidity, greater variability around outcomes and often less accessibility where privately held.

But risk-mapping across asset classes in the time of Covid-19 may need to be more granular than in the past as countries, sectors, companies and currencies will deliver different risks and benefits, depending on their recovery trajectory and indebtedness. Comparing these different risks - and taking sustainability factors into account - can help build a truer picture than considering standard deviations alone.

“It makes sense to use a richer set of risk considerations right now. Plotting the implied volatility in asset price movements and the impact on overall returns over time remains valid, but we also need to ask what types of risk factors portfolios are truly exposed to,” says Andrew McCaffery, Global Chief Investment Officer.

Other risks investors may be exposed to include crowded trades. With rates so low, the temptation to chase growth has been greater than ever, and there has been significant concentration in technology stocks, especially in the US. Any unwinding of this could hurt many types of assets. Central bank support may also encourage investors back into sectors where solvency risk remains high.

Factors such as momentum, size, quality and value may drive similar patterns across asset classes, undermining headline diversification. But as well as managing these risks, there are proactive ways to play factor exposures.

For example, value has underperformed growth for many years now and has continued to underperform this year. However, if investors take the view that, at some point soon, the cycle will turn and the solvency of many companies in this profile is assured, then value stocks will be sought after, which could allow a tilt to value the potential to achieve a better risk-adjusted return in future.

Understanding how to diversify portfolios effectively is crucial in an environment dominated by two opposing forces. On the one hand, the impact of central bank and government stimulus on risk assets appears significant and may drive up valuations. On the other, the economic damage is extensive, debts are mounting, and confidence is low - all of which will weigh on earnings. Political tensions between the US and China are also on the rise.

While these forces may prevent big changes in positioning, investors with a more bullish view on the shape of the recovery may consider shorter-term plays, e.g. in the energy sector where demand could rise from very low levels, and coincide with supply reducing. Chinese consumers may also create opportunities as their economy was “first in [to the crisis] and first out” and value could outperform in the early stages of a global recovery.

If investors prefer to be more defensive, there are various ways to protect income and capital. If real rates remain negative, gold could be a useful diversifier, while holding currencies such as the yen may help mitigate equity and credit market risks.

“We could enter a period where returns and income are harder to come by. So for those investors who can bear the illiquidity, I see a bigger role for alternative investments in a balanced portfolio. Within alternative linked strategies, I also see the role of leverage changing - being used to amplify defensiveness rather than directed purely towards returns,” says Rikkerink.

For regulatory and structural reasons, retail investors have often been less able to access alternatives than institutions. That could change if growth in distributive ledger technologies and tokenisation allows for greater fractional ownership of these products among smaller investors. Other types of investment vehicle may become available as more companies seek to re-capitalise via debt and equity, and governments try to kick-start the recovery from Covid-19.

In the meantime, we continue to advocate a degree of caution, given the increased risk of mean reversion as markets have got ahead of themselves relative to 2020/2021 earnings forecasts. We believe now is the time to ensure portfolios are genuinely diversified and can provide greater protection when the next bout of volatility hits.