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Is diversification over?

Fabien Benchetrit

In this article:

    Diversification – exposure to multiple risky assets to help reduce portfolio risk – can enable a portfolio to thrive in many different market environments. However, after an exceptional 2020, events so far in 2021 – with US equities outperforming other equities and asset types – seems to call into question its benefits. Has diversification lost its magic?

    Equity risk dominates in many investor portfolios, in particular US equities. Historically higher returns and the composition of the MSCI World index, with its US weighting of more than 60%, may be part of the explanation.

    In addition, the US equity market, with a cumulative performance exceeding 260% over the past decade, has significantly outperformed other markets.

    The performance over the first four months of 2021 paints much the same picture, with a clear outperformance of US equities (MSCI USA index +10.7%) over other regions (MSCI Asia index +3.22%) and other asset types (Bloomberg Barclays MSCI Global Aggregate Credit -2.46% index).

    The ‘McDonald’s & Pizza Hut’ portfolio, or ‘understanding diversification’

    Many investors believe that holding a host of different funds or equities in a portfolio will result in high diversification gains. This is not so. Take, for example, two equities: McDonald’s and Pizza Hut. Both companies are active in the catering sector and are present in the US and overseas.

    An historical look at their activity levels shows that McDonald’s business increases with the number of sunny days as customers are happy to venture out. Conversely, Pizza Hut generates most of its turnover from home delivery and turnover increases in rainy weather. The combination of these two equities ​​in a portfolio reduces the sensitivity to different weather conditions.

    While that reasoning seems logical, a much more significant force is influencing both companies, namely the prospects for economic growth in the US and around the world. Here, there is a relatively high correlation. In other words, these stocks will likely both fall in value if growth is weaker than expected. This weakens the benefits of (in this case, poorly understood) diversification.

    Finding the right recipe: Seek the efficient frontier

    Furthermore, it is commonly accepted that the long-term return on an asset is proportional to its risk. Exhibit 1 illustrates this relationship between risk and return. Sovereign bonds are often less risky than equities issued by companies and therefore less profitable. So, to achieve a high return, one must also accept a higher level of risk.

    However, by employing broad geographic and asset class diversification, it becomes possible to invest in risky assets offering potential for high returns while reducing the overall level of risk in the portfolio. Diversification is thus about seeking ‘the efficient frontier’, or the right combination of different kinds of assets whose returns exhibit, if possible, a low level of correlation.

    Exhibit 1: Excess return vs. volatility

    Source: BNPP AM, 2003 to 2020

    A balanced menu: How to combine assets with different risk profiles

    Portfolios are often said to be ‘balanced’ when they contain equal portions of equities and bonds. However, this is not the case, as the equity risk would dominate the overall risk in the portfolio. Equities are simply much more volatile than bonds.

    The consequences for the portfolio are significant because it loses resilience – its capacity to thrive in many different market environments. The bond allocation will not be able to play its full role and its diversification qualities will be under-exploited. Sovereign bonds, for example, will not act as a sufficiently safe haven in times of financial market stress.

    This is why, as part of our investment strategy based on volatility control, which we call IsoVol, we define risk budgets by asset. Risk then becomes a priority and determines the level of exposure of each asset class and not the other way around. This ensures the stability of the portfolio’s risk profile.

    As we have already explained in detail in previous notes,[1] portfolios constructed in this way do better with regard to the risk incurred. These portfolios can achieve diversification levels of around 50%. The risk of a portfolio managed using risk budgets is up to 50% lower than the sum of the risks of each asset. Exhibit 2 shows the differences in asset volatility as well as an equally weighted portfolio.

    Source: BNPP AM, 2003 to 2020

    Choosing the right ingredients: Which assets to select?

    Different economic environments are characterised by periods of growth, stagnation or decline, and higher or lower inflation. As illustrated in Exhibit 3, by choosing a wide range of assets suited to different economic environments, they can take turns to ensure a stable performance over time.

    Thus, stocks typically rise in times of strong growth, while sovereign bonds or listed real estate will produce higher returns in other contexts. Likewise, in a period of accelerating inflation and slowing growth, bonds issued by emerging countries or commodities tend to appreciate strongly. “History doesn’t repeat itself, but sometimes it rhymes.”

    Exhibit 3: Different asset types are suited to different economic environments

    Revisiting world cuisine: Which geographical areas to choose?

    Diversification can be weakened by geographic concentration. There is often a domestic bias among investors, favouring assets in one’s home country (or the sector for which one is professionally responsible) to the detriment of foreign assets – even if the development prospects are better overseas.

    Leaving aside from political or monetary crises, there is often a significant performance gap between the best-performing and the worst-performing national indices. By construction, indices select equities, distinguishing between companies with a high capitalisation and less capitalised companies.

    However, history shows that no country consistently outperforms other countries. Indeed, outperformance leads to overvaluation, giving rise in turn to an adjustment or a correction.

    While US equities clearly outperformed other markets from 2010 to 2020, they were among the worst performers from 2000 to 2010 after the dot com and subprime crises (see Exhibit 4). A geographically diversified portfolio in the main regions (Europe, North America and Asia) will likely be less sensitive to any isolated accident and will offer a more regular return profile over the medium term.

    Exhibit 4: Performance of main national equity indices (total return, local currency terms)

    What’s on the menu in 2021?

    The first quarter saw (once again) a clear outperformance of US equities vis-à-vis other markets. Portfolios exposed to the MSCI World index, 64% of which is US equities, significantly outperformed portfolios with an equivalent level of exposure, but with greater geographic diversification.

    Short-term underperformance is never comfortable, but we firmly believe that maintaining strong geographic diversification is essential. In recent years, the economies of developed countries have become increasingly interconnected due to globalisation, the free movement of capital, the economic superiority of the US and a stable geopolitical framework.

    The Covid-19 crisis highlighted declines at a national levels: treatment of patients, access to vaccines, masks, etc. The pandemic acted as a catalyst, accelerating the shift towards a less unipolar and less correlated world.

    We expect these changes to be significant in the case of China. Indeed, while its monetary policy is independent of the rest of the world, it does not yet occupy the world rank it deserves in relation to the size of its economy.

    The addition of Chinese assets to a portfolio allocation is now possible thanks to improved liquidity, the development of organised markets and dedicated instruments in both equities and bonds. Chinese assets will help improve diversification. Its growth will likely fuel a deglobalisation movement that is focused less on the US in the years to come.

    Traditional portfolios often fail to take full advantage of the benefits of diversification by not taking into account the different risk profiles of assets and by limiting themselves to assets whose behaviour is too homogeneous.

    We firmly believe that the construction of risk-budgeted (IsoVol) portfolios, selecting assets of different kinds and with a weak correlation allows us to achieve higher long-term returns, while reducing overall portfolio risk. Geographic diversification will be even more essential in the future to continue to deliver consistent performance in a more complex environment.

    [1]A new generation of flexible strategies – Navigating with a ‘foil’ at (February 2021)

    Please note that articles may contain technical language. For this reason, they may not be suitable for readers without professional investment experience. Any views expressed here are those of the author as of the date of publication, are based on available information, and are subject to change without notice. Individual portfolio management teams may hold different views and may take different investment decisions for different clients. This document does not constitute investment advice. The value of investments and the income they generate may go down as well as up and it is possible that investors will not recover their initial outlay. Past performance is no guarantee for future returns. Investing in emerging markets, or specialised or restricted sectors is likely to be subject to a higher-than-average volatility due to a high degree of concentration, greater uncertainty because less information is available, there is less liquidity or due to greater sensitivity to changes in market conditions (social, political and economic conditions). Some emerging markets offer less security than the majority of international developed markets. For this reason, services for portfolio transactions, liquidation and conservation on behalf of funds invested in emerging markets may carry greater risk.

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