We face a diversification dilemma, a crisis in portfolio construction. The negative returns for fixed income year-to-date has led to a silencing of the “bonds are back” brigade and again led investors to question why they should hold the asset class in their portfolios.
This has been exacerbated by the recent positive correlation between equities and bonds, it’s little surprise then that investors have been questioning conventional methods of diversification.
After both asset classes delivered negative returns in 2022, bonds, often a safe-haven in periods of disruption, more importantly did not provide the traditional cushion to equity market volatility.
Fast forward, the case for diversification has been further dented as equity market returns in 2023 were dominated by a handful of US companies dubbed the ‘magnificent seven’ (Apple, Microsoft, Alphabet, Amazon, Nvidia, Tesla and Meta), which delivered staggering growth in excess of 100% over the year, dwarfing the healthy but relatively more muted returns of the S&P 500, which grew over 26%. To put this into context, over the same time period the S&P ex Magnificent 7 Index is up just over 12%. Indeed, this “concentration conundrum” has been a trend that has been building over the last decade.
These events only reinforce the view that we indeed are facing a diversification dilemma. They have also led to many commentators questioning how fit for purpose the traditional balanced model of 60/40 investing in equites and bonds now is.
The right baskets
While in this complex environment the old adage of not ‘putting all your eggs in one basket’ rings truer than ever, having baskets does not necessarily mean they are the right baskets if they all behave in the same way.
The lure of the traditional balanced portfolio has been its ability to limit losses in challenging stockmarkets through using bonds, which historically have been more stable at times of intense volatility. However, as recent events show, despite looking diversified, your proverbial eggs still need to be carefully managed.
An assessment of the economic backdrop paints a picture of uncertainty. This uncertainty feeds into asset allocation, highlighting the importance of building diversified portfolios to thrive throughout periods of turbulence. Mixing and matching different assets, each with their own patterns of returns, remains crucial.
Given that all major developed equity markets offer a significant valuation discount to the US, one may find it prudent from a diversification perspective to spread risk across the cheaper markets. US equities have taken up a larger allocation of global equities over time – going from less than 40% in 2013, to over 66% today.
We have also seen concentration risk within the US market increase significantly, which has meant that the top 10 stocks have increased their share from just over 10%, to well over one third today.
This has led to global concentration risk like we have never seen in recent times. Of course, the US could continue to outperform. However, the concentration conundrum debate can no longer be purely about return, it must be about the risk you’re taking to generate that return.
We are still late cycle in the US and floating close to a technical recession in Europe. While the UK fell into a technical recession in the latter part of 2023, a deep global recession seems unlikely in the near term as the impact of rate increases have not been as detrimental as expected.
Investing late cycle is always difficult. Historically, risky assets perform well in this period, however, volatility can increase as markets assess the likelihood of a recession. It is this uncertainty that increases the case for diversification.
Driving long-term performance
Finding the right blend of equities, bonds and alternatives to meet your goals is the main driver of long-term performance. So from this perspective the 60/40 model remains applicable, but we must interrogate the approach further.
Different asset classes will perform well in different types of markets and while the breakdown in negative correlation between equities and bonds gives portfolio builders a headache, it should be noted that this was driven by an unanticipated and rather abrupt inflation spike. Looking through the short-term noise and reassessing fundamentals rather than reacting would be a sensible approach for medium-term investors.
Indeed 60/40 may be the ideal split for many, but investors need to think about other asset classes to add to the mix to achieve robust diversification.
Let us take the 60% allocation to equities to start with. Indeed, the difference in performance between US large caps and emerging market small caps over recent years is a prime example that the “60” can give many different client outcomes. That is before we even start to think about the way to get that exposure. We must think beyond just purely actively-managed equity strategies, and embrace those that replicate indices, systematic strategies, sector strategies and so on and so forth. Each can give significantly different outcomes for investors.
Then within your 40% in bonds of course you also have to think where you want to be on the active-passive continuum and after that it becomes even more nuanced. It is not just about gilts, you have to take into account global bonds, inflation-linked bonds, corporate bonds, high yield, emerging market debt, overall credit quality, portfolio duration and potentially even more esoteric bond exposures such as convertibles or catastrophe bonds.
Finally, when we think about alternatives assets, they clearly have a role in a multi-asset portfolio yet bucketing them as a predetermined allocation feels both imprudent and imperfect. The tool set within alternatives is vast and investors really need to assess the merits of each opportunity relative to their current split before allocating blindly. If that greater diversification comes with a higher fee, more liquidity risk, greater manager selection risk or more complexity, investors need to decide what is the ideal balance for them.
We are indeed facing a diversification dilemma. Diversification is highly nuanced, and while a 60/40 portfolio may indeed be the right choice for many, the way in which it is constructed needs to be robust. The underlying drivers of each different asset class can behave very differently, and to not account for this would be a naïve approach.
A clear thought process of generating the strongest return utilising the entire universe for a particular risk level, in an evidence-based manner, is most sensible rather than arbitrary fixed allocations to equities and bonds … or alternatives.
Justin Onuekwusi is chief investment officer at St James’s Place
