‘Diversification is broken.’ ‘Multi-asset solutions rely on bonds and will underperform.’ ‘The 60/40 portfolio is dead.’ These views have been echoing in the market since the collapse in yields across the globe in the first quarter of this year.

But there are several incorrect assumptions behind these statements. Relying on bonds alone for diversification has always been a false dichotomy – holding two asset classes is not a ‘multi-asset’ portfolio. True multi-asset approaches have always used a much wider array of tools to achieve diversification and manage risk. Whether you want a decent total return or a consistent yield for a reasonable level of risk, flexible multi-asset strategies have plenty of options at their disposal.

Active asset allocation

With interest rates at 5,000-year lows1, bonds cannot keep churning out the great risk-adjusted returns of the last few decades. So far, capital losses in core fixed income have been short lived. But that may be about to change.

A dynamic portfolio that can alter its asset mix throughout the economic cycle is key. A rigorous macro process can materially improve risk-adjusted returns by increasing those assets helped by the cycle and reducing those hampered by it. Focusing on correlation risk and diversification can mitigate against painful equity drawdowns. Being able to act quickly is paramount.

Diversification isn’t just about downside protection. Listed equity options can provide a tactical upside hedge. For most of 2020, owning growth and technology equities was a great trade, but in the autumn, you’d have missed out on a large rally in value-heavy indices. In contrast, holding cheap tactical options in a value-oriented market such as Japan alongside core growth equities allowed a multi-asset portfolio to participate in a sharp factor rotation.

Relative value strategies can be a good way to make a return for much less risk than simply taking a directional bet. For example, in the first ten months of 2020 US equities outperformed Europe by 17%. Being long US and short Europe made money, for comparatively little risk: the short European side of the trade cancelled out much of the risk from the long US side.

Granular exposures

Forty years of a bond bull market have allowed investors the luxury of stable diversification. When risk assets lost money, the compensation from falling bond yields masked inefficiencies in passive or index-orientated equity portfolios.


But a recent feature has been a decline in long-term growth and inflation expectations. This has caused higher quality, growth equities to hugely outperform lower quality, value stocks given their greater sensitivity to interest rates; most notably with the outperformance of technology (the ‘FAANGs’). Multi-asset portfolios that selected the right parts of the equity market outperformed those that bought the whole market passively. Active stock selection is key. So is being very granular about your exposure by holding tailored equity ‘baskets’: having smaller baskets of stocks you really want is more efficient than buying the whole market.


Multi-asset portfolios that selected the right parts of the equity market outperformed those that bought the whole market passively. Active stock selection is key. So is being very granular about your exposure by holding tailored equity ‘baskets’: having smaller baskets of stocks you really want is more efficient than buying the whole market.


This approach shouldn’t be restricted to equities. In fixed income, holding a concentration of deeply researched bonds, whose creditworthiness you understand, is more effective than buying the whole credit market. In this way, a fund manager can tailor risk and return to suit the needs of the portfolio and their investors.

Embrace new ideas

The need for a number of diversifying levers to pull has never been greater. Foreign exchange (FX), commodities, and downside protection all play critical roles.

FX is an integral part of portfolios. Pinned low interest rates mean FX is increasingly the ‘release valve’ of macro divergencies. FX adds flexibility and can be a return enhancer or diversifier, whether using ’safe haven’ currencies to diversify a portfolio, such as Japanese yen, or owning higher yielding emerging market currencies to gain carry. Commodities can also act as diversifiers: gold is well known, but silver, copper, and even agriculture can play a role.

Finally, it’s important to remain open to new ideas, because financial markets are constantly innovating. Futures on the VIX, aka the ‘fear’ index, have been around for a long time. They are listed, liquid, and a good way to generate returns when markets are in turmoil. Held alongside more traditional downside protection tools, such as equity insurance via put protection or simply shorting equity futures, this is another useful risk mitigation lever.

Since the crisis, US Treasuries have been range-bound: the diversifying power of VIX futures has been much greater Diversification is not dead

Since the crisis, US Treasuries have been range-bound: the diversifying power of VIX futures has been much greater

Source: Bloomberg. S&P 500 Net Total Return Index, 10-year US Treasury futures, and Chicago Board Options Exchange Volatility Index, from 1st January to 31st October 2020.

Conclusion

Diversification may be more difficult to find now that a permanent allocation to the US 10-year Treasury is no longer a one-way bet – indeed, a potentially more inflationary environment could make it a losing one.2 But there are many ways to diversify, and for risk-conscious investors looking for a total return or reasonable yield, multi-asset portfolios may be an appropriate solution.

1 The first evidence of compound interest was recorded in Mesopotamia around 2400 BC, with annual interest rates of around 20%: 
https://www.bbc.co.uk/news/business-39870485
2 A hotly debated topic.

Please note

Please note: Market and exchange rate movements can cause the value of an investment to fall as well as rise, and you may get back less than originally invested. The views expressed are those of the individuals mentioned at the time of writing are not necessarily those of Jupiter as a whole and may be subject to change. This is particularly true during periods of rapidly changing market circumstances.

Important information

This document is intended for investment professionals and is not for the use or benefit of other persons, including retail investors, except in Hong Kong. This document is for informational purposes only and is not investment advice. Every effort is made to ensure the accuracy of the information, but no assurance or warranties are given. Holding examples are for illustrative purposes only and are not a recommendation to buy or sell. Issued by Jupiter Asset Management Limited which is authorised and regulated by the Financial Conduct Authority, registered address is The Zig Zag Building, 70 Victoria Street, London, SW1E 6SQ, United Kingdom. For investors in Hong Kong: Issued by Jupiter Asset Management (Hong Kong) Limited and has not been reviewed by the Securities and Futures Commission. No part of this content may be reproduced in any manner without the prior permission of Jupiter Asset Management Limited or Jupiter Asset Management (Hong Kong). 26653