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Diversification

In a world of rising asset class correlation, diversification is more important in portfolio construction than ever.

This is especially true if markets were to dip or we entered into a bear market period. Asset prices have generally been pushed up over the past few years through a combination of quantitative easing (by any name) and near zero interest rates. It’s probably true to say that the most influential market participants have been the central banks.

Low yields have seen Investors corralled up the risk scale to meet individual return requirements. At the same time increased regulations have helped reduce liquidity leaving bond markets highly sensitive to investor sentiment. As Mike has highlighted in recent newsletters and blogs this is spilling over into equity markets, increasing the correlation between asset classes.

Central bank influence is something that I feel is likely to be prominent over the coming years as investors continue to interpret every nuance when new information is drip fed into the market. A prime example was seen just this week as ECB (European Central Bank) Executive Board member Benoit Coeure said they will boost asset purchases in May and June ahead of a drop-off in market liquidity in the summer. The following day saw 10 years bunds up 0.37%, the MSCI Germany up 2.29% and the euro weaken against the dollar by 2.13%.

US Federal Reserve Chair Janet Yellen’s remarks just a few weeks ago that equity market valuations are “quite high” but not when compared to returns on bonds where returns are very low have drawn comparison to similar comments from predecessor Alan Greenspan. In 1996 Greenspan commented that the stock market was showing signs of ‘irrational exuberance’. It must also be noted that the bull market continued until March 2000 before falling, the S&P fell c35% over the following 18 months.

There is a common saying, ‘don’t fight the Fed’, recently David Tepper founder of $20b hedge fund Appaloosa updated it to ‘don’t fight the four Feds’. In short don’t fight money. Now with Europe, Japan and China effectively carrying out quantitative easing he sees more opportunity in equities - he even feels the S&P is a little “cheap”.

There are a lot of conflicting views, it would be great to pick the winner every time but in reality is never going to happen.

As portfolio constructors we need to position the portfolios for a number of scenarios. As returns from traditional asset classes have converged we continue to look beyond just equity, fixed interest and property.

We have been spending some time recently carrying out correlation analysis on our portfolios using past scenarios such as 2000 and 2007 market crashes and the correlation between assets to model possible behaviour of our portfolios. In the event of a big drop in equities we are confident that our portfolios will most likely drop significantly less.

Whilst the analysis won’t help us avoid a crash, or forecast a crash even, it should help pre-empt the disruption. By doing so it can help take some emotion away from the situation so we are able to make rational decisions. It can give us a basis for how we would manoeuvre the portfolios to reduce losses and hopefully take full advantage of any rebound.

Our alternative equity portfolio tries to give us this diversification at the same time as generating returns for the broader model. It is made up of multi-strategy funds that can go both long (making money when the market goes up) and short the market (making money when it goes down).

It’s correlation to our balanced equity portfolio has been -0.59 over the past 6 months – it has been negatively correlated. Returns have been lower than equity but it is nice to have the reassurance that this element of the model could potentially yield positive returns or fall less if equity markets dipped.

From the beginning of 2008 to mid-March 2009 our equity portfolio fell nearly 40% whilst our alternative equity portfolio fell just 8%. Over the 12 months following the equity portfolio returned over 60% whilst alternative equity went up by just 13%.

We look to ensure our clients investments are positioned to not only benefit from rising markets but also protect in falling markets. After all protection in falling markets gives us the opportunity to partake more in the event of a recovery by switching money into stocks and buying at cheaper prices.

Whilst I’m aware this all sounds very bearish, we are actually cautiously optimistic on the outlook for equities. This ongoing analysis and questioning ‘what if’ gives us confidence our positioning is correct.

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