Multi Asset Investing – Diversification

Multi asset investing has many attractions from an advisers perspective – it is a way of outsourcing the ongoing management of client funds in a cost effective way – and key to this are the diversification benefits it brings, not just in the initial portfolio but on an ongoing basis through the fund management and rebalancing.

Diversification is key to managing risk in a portfolio, and so to understand this we need to look more closely at risk, and the different types investors are exposed to.

Diversification is a subject which investors should have high up on their agenda when planning a portfolio and most investors understand the principle – which is to spread assets across a number of different asset classes, sectors and geographies to deliver the best return for a given level of risk. Combinations of assets that do this are said to be on the efficient frontier as defined by Harry Markowitz in 1952 – this is the cornerstone of what is called Modern Portfolio Theory. The efficient frontier is the point where a portfolio reaches its optimal combination of assets to achieve the best return for the risk taken. We will not dwell too long on this, only to understand that in investment theory at least diversification is at the heart of maximising risk and return.

Diversification is key to managing risk in a portfolio, and so to understand this we need to look more closely at risk, and the different types investors are exposed to. Fundamentally there are two types of risk to address. Firstly systematic or 'market risk', which is a risk that diversification cannot address and it is associated with every type of asset. Causes of systematic risk are things like inflation rates, exchange rates, political instability, war and interest rates. This type of risk is not specific to a particular company or industry, and it cannot be eliminated, or reduced through diversification; it is just a risk that investors must accept.

The second type of risk is unsystematic risk and this is specific to a company, industry, market, economy or country, and it can be reduced through diversification. The most common sources of unsystematic risk are business risk and financial risk.

A diversified portfolio will invest in a range of assets so that not all will be affected in the same way by market events. In simple terms, the more concentrated a portfolio, the greater risk there is that if a negative event occurs affecting markets related to the assets you are holding, then they could all fall in value. If this risk has been spread by holding non correlated assets – that is those which react in a different way to the event - the chances of significant loss are lower. There are always exceptions to this, such as a crisis that transcends all of these normal correlations, as we saw with the 2008 global financial crisis.

The benefits of diversification are perhaps best illustrated with an example. If a portfolio were held in only one type of stock – for example airline stocks – and an event occurred affecting that industry – for example an indefinite strike by aircraft staff – then the share prices of all the stocks will drop, having a dramatic effect on the entire portfolio. If however the portfolio also held some stocks to counterbalance this risk, for example rail company stocks, then only part of the portfolio would be affected, and indeed the rail company stocks may increase as a result of higher demand for its services.

Of course it is possible, and indeed preferable, to diversify further than this – as there are many events that would affect all transport stocks. This is the impact of correlation. Any event that reduced travel overall would affect the whole portfolio, so it would be argued that train and air travel stocks have strong correlation. In order to achieve better diversification, you would want to diversify more comprehensively, not only investing in different types of companies but also in different types of industries. The more uncorrelated the stocks are, the better.

In simple terms, the more concentrated a portfolio, the greater risk there is that if a negative event occurs affecting markets related to the assets you are holding, then they could all fall in value.

Constructing a diversified portfolio involves a number of layers, from the macro or headline level – choosing between equity, bonds, property, cash, commodities, and alternatives – to decisions on geography, and ultimately decisions on individual sectors and funds (or even companies if direct equities are included) and potentially other levels in between. Diversification is simple to understand but far more difficult to deliver effectively.

Once a portfolio is in place, it is just as important to monitor it, and look at the attribution (how and why a portfolio differed from its benchmark) as this can illustrate where there are biases and unintended risks in a portfolio. Holding a range of mutual funds from different managers may seem to offer diversification but if all the managers have 10% in Vodafone for example, then the underlying concentration risk may be higher than first thought. Similarly, holding funds from a number of managers with the same or similar style or process would not represent a diversified portfolio as the funds would be highly correlated and if the market moved away from this style the portfolio could perform much worse than one which included a range of styles.

Portfolio construction is a careful balancing act, as it is also not wise to over diversify as this can work against a portfolio as well. Splitting a portfolio into many small packages can incur higher transaction costs and can mean that the holdings are so small that the portfolio doesn't really benefit from holding the right stocks as they are in too small a quantity to influence the overall return.

In summary, the principle of diversification is generally well understood and is a vital part of portfolio planning. This simple initial message is however much more complex when looking to execute effectively to meet different client requirements. This is where multi asset funds run by professional fund management groups can help to deliver the right level of risk adjusted returns.