Juan Nevado, M&G Investments
The fluctuations in returns that investors can sometimes face when they hold only a single asset class in their portfolio may be larger than they would welcome.
However, investing in multi-asset portfolios, across different assets or asset classes, is usually considered a good way of gaining diversification, and reducing the chances of suffering significantly negative returns. Of course, even then, there can be no guarantee that investors will not lose money.
Ever-changing relationships
Diversification comes from the expectation that different asset classes will react differently to market news, rather than in the same way or even in the same direction. The benefits of diversification for a multi-asset strategy hinge on that characteristic.
However, over time, the way assets react to news tends to change, and so the relationships between different assets also changes. Therefore, simply spreading investments across asset classes may no longer be enough in the current investment environment.
Evidence suggests that the dynamic seen for much of the last 20 years, where equities and bonds tended to respond to important news by moving in opposing directions, could be changing.
The first quarter of 2018 represented the first time in that period that a meaningful increase in the VIX Volatility Index (a measure of how much market participants think US equity prices might fluctuate in the short term) was accompanied by declining US government bond (treasury) prices.
This dynamic is heavily influenced by the backdrop for interest rates, which has been changing for some time. Major central banks are now at varying stages of unwinding their extraordinarily loose monetary policy stances.
This changing environment could prompt meaningful changes in the relationships between asset classes, which is a key element of successful diversification.
As an example, looking back to early 2018 again, US equities and bonds were both weak, as rising US interest rates and prospective returns from US treasuries contributed to weaker and fluctuating equity prices. Previously, increasing interest rates were more likely to accompany stronger, equity-supportive economic growth.
Non-traditional strategies
This changing regime for asset relationships may mean that diversification will have to be achieved through less traditional means; more sophisticated, multi-asset strategies and approaches may be required.
One example would be that of relative value strategies – essentially, within similar asset classes, buying the ones that are out of favour and selling those that are considered to be overpriced, thus taking advantage of the price difference.
Active currency and interest rate risk management, and more targeted exposures to factors that are not sensitive to interest rates are also among the more sophisticated approaches.
Tactical adjustment of exposures in response to short-term market turbulence could be another key source of diversification for multi-asset investors. M&G’s Multi Asset team believes that asset prices can be periodically driven by behavioural, rather than fundamental, factors. Then, as behavioural forces abate, fundamental forces reassert themselves on asset prices to better reflect their fair value.
We believe that investors who are prepared to commit capital to capture such episodic opportunities could both enhance returns and add diversification to their multi-asset portfolio.
Currently, it appears policymakers are moving away from the post-financial crisis environment of extended ultra-low interest rates. However, it is impossible to predict how interest rates will move over time.
Similarly, the reaction of bond and equity markets may not be predictable. Instead, it will be important to pay attention to their relative valuations as investor sentiment shifts.
We believe that investors should focus on value. Many assets across the world continue to offer a significant valuation buffer against the pressure of rising interest rates in developed markets. For example, certain countries within emerging markets have not been beneficiaries of the low-rate environment elsewhere, and therefore should be less vulnerable as rates edge up.
As investors grapple with the impact of rising rates on other assets, periods of market fluctuations can be expected across geographies and asset classes.
Dynamic multi-asset investment strategies, which can respond to the opportunities that these periods present, could identify new sources of diversification when previous relationships break down.
Juan Nevado is a portfolio manager at M&G Investments
