A key principle in modern day investment management is to ensure that an investor maintains a well-diversified portfolio of assets. With a desire to protect themselves against changes in risk sentiment and swings in market conditions, investors have utilised traditional diversification strategies across asset classes, sectors, and geographic regions to remove unsystematic risk from their portfolios. During times of rapidly changing market conditions, investors are consistently reminded of the importance of diversification, and the first four weeks of 2022 provided an example of this. That being said, increasingly globalised markets have strengthened the correlation amongst these traditional diversification strategies in recent years, and a growing number of institutional investors are looking to utilise additional diversification methods to protect portfolio performance in 2022 and beyond.
- What Is Diversification?
Economists have been discussing the benefits of diversification for some time. In the traditional sense, diversification refers to the strategy of building an investment portfolio containing a variety of asset classes such as cash, fixed income, equities, and real assets. In addition, investors will often reduce risk by diversifying their asset allocation between the company sizes, geographic regions, as well as industry sectors.
Despite a plethora of studies reinforcing the need for diversification in modern markets, in recent years, investors have seen the impact of traditional diversification strategies beginning to wane, with traditional asset classes beginning to move in the same direction. Using this quarter as an example, while market sentiment has been heavily impacted by a rapid increase in geopolitical tensions, bonds and equities have also struggled as expectations for inflation and interest rate hikes have risen, causing investor portfolios to face heightened headwinds across asset classes.
Considering this, with traditional diversification techniques not providing investors with the peace of mind that they had come to expect in previous crises and periods of uncertainty, investors are increasingly considering other strategies, such as risk factor diversification.
- Diversification in Modern Portfolio Construction
Risk factors can be understood as the underlying risk exposures that drive the return of an asset class. The adoption of a risk factor-based approach requires a forward-looking macroeconomic view on a range of variables such as monetary policy, geopolitical developments, inflation, interest rates, and economic growth trends amongst other things. While risk factor diversification is similar to other diversification strategies, it places a greater focus on forward-looking macroeconomic expectations, encouraging investors to identify whether seemingly different exposure within a portfolio truly mitigates certain risk factors. From our perspective, risk factor diversification has always been ingrained within our flagship OBI strategy, with our experience in understanding risk factors differentiating our offering from more traditionally diversified asset managers. In recent years, risk factor diversification has been key to generating higher risk-adjusted returns throughout the economic cycle.
By diversifying across risk factors, investors could be better protected from the selling contagions that have occurred at times over the past two years. This approach was examined in Ilmanen and Kizer’s 2012 Journal of Portfolio Management paper on diversification, which observed a stronger performance from risk-factor diversification relative to the traditional asset-class approach for the period of 1973 to 2010.
Having said this, adopting risk-factor diversification can sometimes entail higher trading fees for investors, which could deter investors at times when macroeconomic conditions remain favourable. Nevertheless, the 2012 study found that adopting a risk-factor diversification strategy is still beneficial, as the increase in the Sharpe ratio is significant enough to account for the trading cost differential.
- Our View
Most investors will consider at least some level of diversification within their portfolios, however, the level to which they diversify could vary greatly. The growing importance of considering other diversification strategies is encouraging investors to get ahead of the curve by making changes to their portfolio management processes, and we have subsequently observed an increase in interest in more actively managed portfolio strategies like ours over the past 18 months. Although requiring greater resources, given shifts in investor behaviour, and given the changing relationship between key asset classes in recent years, it’s our view that an investment strategy that incorporates risk-factor diversification within its portfolio asset allocation is likely to be better positioned to mitigate market turbulence throughout 2022 and beyond.
To discuss our actively managed portfolio options, don’t hesitate to get in touch with the team on 01604 621467.
Past performance cannot be used as a guide to future performance and the value of your investment will fall as well as rise in value. You may not get back all of your investment and the final value of your investment will depend on the performance of your portfolio. The actual performance of an individual client’s portfolio may differ due to different funds being used and being restricted in relation to certain asset allocations. Performance figures quoted include fund manager charges but exclude adviser, discretionary, custodian and switch charges. Unless stated, income is reinvested into the portfolio. The information contained in in this document is for information purposes only. It does not constitute advice or a recommendation or an offer or solicitation for investment.