Why diversification is only one element of multi-asset investing

Multi-asset funds boast diversification as their main selling-point. By building a portfolio of low-correlated assets, the idea is that investors maximise their returns by offsetting losses in one asset class against gains in other.

When the European Central Bank (ECB) announced its €1.1trn (£780bn) quantitative easing programme in January, experts suggested the move would drive institutional investors into multi-asset. This was because of the resultant fall in yields on sovereign bonds.

It's an attractive proposition, but there are downsides to look out for. And schemes need to be mindful of the costs caused by regular movements, especially if they are operating under the 75 basis points charge cap.

Glyn Jones, the chief investment officer for dynamic asset allocation at River and Mercantile Group, highlighted the main considerations of multi-asset investing at Pensions and Benefits UK. He pointed out why diversification is not always what it seems.

He said: "The traditional way to think about diversification is around asset classes. But that's actually not the way to think about it

"Let's take Shell, Barclays and a US equity shale company. What drives the return you get for your equity investment in Shell is fundamentally different to what drives your equity investment in Barclays. But it is actually quite like the equity investment in the fracking company in the US.

"Traditionally they've said investing in UK and US equities is diversifying, or that investing in equities and bonds is diversifying. Theoretically investing in Lehman's equities and Lehman's bonds was diversifying. But it's not because they're driven by the same thing."

Jones said the best way to look at diversification was to consider the drivers of return in each asset class. That could be risk transfer through derivative trades or scarcity of the asset class, for example. It could also be economic, like population growth and GDP per capita.

Jones added: "If we've diversified away from equities which had a particular blend of those drivers of return, we've probably pushed our overall return down.

"The good news is that despite pushing the return down through diversification, we can actually make it back with the second element of multi-asset investing, which is asset rotation because the returns from those drivers of return are not constant over time."

Timing is crucial to changing the asset allocations. But Jones is not convinced by managers that say they can beat the market every month or every quarter because of the level of market noise. He recommends taking a one to three-year view instead.

"Trying to do it on a month-by-month basis actually needs a level of foresight that I've yet to find in anyone I've met," Jones said. Still, it is important that the assets are rotated at some point. Otherwise investors can lose out on growing returns from assets that have troughed.

Jones added: "There are quite a few diversified growth funds out there where the assets are hardly ever moved.

"They get the diversification, which will push down the returns - and that may be OK if you only need a low level of returns - but actually, the asset allocation changes are very minor and therefore you don't get that pick up from rotation."

Questions for managers

When selecting a multi-asset fund, trustees need to consider how much diversity of asset classes they want. It may not be appropriate to be invested in alternatives like property or infrastructure because they get that elsewhere, for example. This is an important question to raise with managers before selecting their product.

Trustees also need to look at how the underlying assets are managed. Is it active or passive? Is it in-house or outsourced? And is that coordinated with the asset allocation? Jones added: "There are products out there where the asset allocation manager might be taking risk down in the portfolio because they're worried about the world.

"But at the same time the person managing the equities is positive on the world and is actually putting lots of high risk, high beta stocks into the portfolio and they're almost cancelling each other out. There needs to be coordination there."

A crucial issue is how to assess whether or not the strategy is achieving its objectives. And which benchmarks should be used to determine this. Jones recommends using a combination of three because there is no "right benchmark".

And then trustees have to look at what levels of transparency, return from beta, use of derivatives and economic leverage, they want in their strategy. No fund will provide maximum levels on all four measures, so it is about prioritisation.

Jones said: "The returns you will get in different market environments from funds that look different in this framework will be very different. And if you are looking at funds, decide where you want to be in this frame and then try to pick from the universe."

Jones warns against over-diversification because it is only likely to generate index returns. And he encourages trustees not to take more risk than they are comfortable with. It is also important to look at the way costs are incurred through the movement of the assets because investors want efficiency.

And finally, there is also a capacity constraint on multi-asset funds. Jones concluded: "The capacity in a lot of these funds is single digit billions because when you get bigger than that and you try to move 5% of the assets, you're moving so much that you just can't do it cost-effectively."

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• defined benefit
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