The future of diversification

When we discuss investing, we typically talk about the balance between risk and opportunity, tempered by the balance between preservation and value. Over the last 50 years or so, portfolio managers have sought to achieve this balance by using the relative safety of bonds (government debt) to diversify a portfolio and offset the riskier rewards of equities (company stocks and shares). 

Bonds have historically been the natural go to asset to provide diversification within multi-asset portfolios because they tend to rise in value when equities sell off and vice versa, playing a significant role during times of market volatility.

However, as we have seen in recent years, this hasn’t always been the case during external shocks to markets, such as the invasion of Ukraine and subsequent rise in energy costs, or the advent of tariffs imposed by the Trump administration.

During these periods bonds fell in value along with equities. The same was true during the steep rise in inflation in 2021-2022 that came after supply chain disruptions caused by the covid pandemic.

In these cases, consumer prices were predicted to rise, crucially keeping inflation and therefore interest rates higher. This weighted the market value of government bonds as yields rose with rates (the trading value of a bond moves inversely to its fixed yield or ‘coupon’).

Meanwhile, equity markets also suffered in parallel, as the growth outlook declined. We therefore saw a correlation of bonds and equites moving in the same direction – limiting the diversification you would expect by holding both bonds and equities together in a portfolio. The below chart shows how this correlation has risen since 2020 following nearly two decades of non-correlation.

Our view is that over the next five years, and potentially well beyond, inflation could settle at higher levels than it did in the decade to 2019 – when in the US it averaged around 1.5%. This new regime means bond yields are likely to remain higher for longer, which could make it more difficult for bonds to perform well as a diversifier due to potential further correlation with equities. While that does not negate the case for holding bonds altogether, given their attractive expected returns, this environment requires us to look beyond bonds to bring diversification to our portfolios.

Diversification is not as easy as simply mixing equities and bonds depending on your risk appetite. We also employ a diversification lens when looking at the timelines of investments, the location of investments and the currencies we transact in, as well as the nature of the assets themselves.

Our Anchor & Cycle investment process considers different time horizons and different performance drivers and is therefore an inherent source of diversification.

Anchor is our long-term strategic model, designed to allocate across core asset classes when we expect them to deliver superior risk-adjusted returns over time.

In contrast, Cycle is our tactical, shorter-term engine. Cycle is more actively managed to capture opportunities across asset classes by responding to anticipated shifts in the macroeconomic environment and the corporate earnings landscape. 

‘Liquid alternatives’ are alternative in that they do not necessarily correlate to the traditional bond vs equities relationship – thereby providing another dimension of diversification which will be important given slower growth in a high inflation environment.

Liquid alternatives have some key diversification characteristics – they employ short selling, allowing us to take growth opportunities even if markets contract, and their ‘liquid’ nature allows us to sell in and out, giving us flexibility.

Liquid alternatives also give us flexibility through different timelines and access to different parts of the market – ensuring we have the value of active diversification in our portfolios.

Liquid Alternatives in practice

Liquid alternatives cover a wide range of asset types, meaning they can take advantage of specific potential growth areas, even when the broader market may be challenged. This independence makes them attractive over traditional funds which typically hold equities and bonds.

As an example, our own liquid alternatives fund – the Coutts Diversifying Alternatives Multi-Manager Fund – allows us to invest in a business that specialises in semiconductor manufacturing, a key part of the supply chain for the burgeoning development of AI. This focus allows for potential returns irrespective of the direction of broader market movements.

Where our funds have a significant allocation to bonds, this exposure to a liquid alternative can provide valuable diversification, mitigating the potential for reduced returns as these assets are not sensitive to the same risks.

Finding new routes to active diversification in this way continues to serve our Anchor & Cycle process and aims to benefit client investments through market rallies and slowdowns.

The value of investments, and the income from them, can fall as well as rise and you may not get back what you put in. Past performance should not be taken as a guide to future performance. You should continue to hold cash for your short-term needs.