Diversifying assets are important but don’t necessarily look for a big payoff
At Rathbones, we take a multi-asset approach to investing, which provides us with the flexibility to meet individual needs. In order to construct portfolios effectively and manage risk, we divide assets into three building blocks, which play different roles – liquidity (mostly safe-haven government bonds and cash), equity-type (such as shares, corporate bonds and emerging market debt) and diversifiers.
This third category comprises assets that demonstrate a low or negative correlation to equities, particularly during periods of market stress. They include precious metals, non-directional alternative strategies, targeted return strategies and unleveraged commercial property.
Although these assets tend to exhibit diversifying characteristics across a range of environments over the long term, the performance of the different types of strategies can vary significantly over shorter periods. From a tactical perspective, it can be helpful to consider which diversifiers are most suited to the current investment climate.
Actively managed strategies
We believe the environment for some strategies has become less favourable. For example, returns within equity markets have become less dispersed, M&A activity remains subdued and common factors (such as value and growth) are starting to drive the return of a wider spread of equity-type assets.
However, we continue to believe that overweighting these assets is still important for generating attractive risk-adjusted returns in a balanced portfolio. Although over the past three years our diversifiers have not beaten US equities, they are not supposed to. Indeed, we would be highly concerned if they had.
Instead, most of the strategies we invest in have delivered steady, small, uncorrelated returns, which is what we would expect from assets that are meant to provide a form of protection against periods of market stress. However, we acknowledge that some of these strategies have struggled over the past year.
The correlation between equities and many of our diversifying assets remained low or even negative during the difficult markets in the first half of the year. This is likely to be more important than ever over the next year or two, when we believe markets are likely to suffer recurring bouts of volatility, driven by rising bond yields.
Hedging your hedge
Over the quarter, gold has struggled in a strong dollar environment (figure 6). Any weakness in the dollar may strengthen gold prices, but non-dollar investors need to be aware of the currency impact of holding gold (a dollar-denominated asset). If this currency exposure is unhedged, any gain in gold prices from dollar weakness would be eroded when translated back to sterling.
Figure 6: Gold price (dollar per troy ounce)
Gold prices have not performed as expected against a background of economic and political uncertainty, with dollar strength weighting on the precious metal.
Source: FactSet and Rathbones. Past performance is not a reliable indicator of future performance.
There are three parts to the argument for owning gold. First, it looks oversold on a short-term basis with a substantial number of speculators betting on prices falling further. Second, on a longer-term basis, the dollar looks overvalued and any weakening from here could benefit gold. Third, historically it is one of the best hedges against mistakes in government policy, be that monetary (such as interest rates) or fiscal (such as spending or taxation) and any economic turbulence they may unleash.
At the moment, we believe the biggest argument against holding gold is the potential for a continued rise in US real rates (interest rates less inflation), given forecasts of further Federal Reserve rate hikes. That would be kryptonite for gold, given the opportunity cost of holding an asset with no income. Although seen as a geopolitical risk hedge, it has also been weak in the face of escalating trade tensions between the US and China.
Gold has historically been weak when the dollar has been strong and vice versa. But UK investors should be aware of the currency impact and hedge accordingly if they are concerned about protecting their gold exposure from the vagaries of currency fluctuations.