Weather-proofing portfolios against market volatility

Diversification has long been used to decrease investment risk by reducing exposure to a particular asset. It works within a single asset class — a portfolio of stocks is less risky than holding shares in one company — but can be more effective across different asset classes.

Some diversification is achieved by investing in government bonds and equities as these two assets usually react differently to macroeconomic news — in simple terms, bonds often rise on bad news and equities fall, and vice versa. However, in extreme conditions, bonds and equities can both fall sharply. Therefore, diversification requires low or negative correlation across different market conditions.

Our investment process uses a number of measures to divide assets into three categories: liquidity, equity-type risk and diversifiers (LED). LED considers how the price of one asset is expected to change in relation to the price of another. It also seeks to recognise how assets behave in diverse market conditions and the expected drivers of asset values under different scenarios.

As one would expect, liquidity and equity-type risk broadly cover cash/bonds and equities respectively, but the dividing line is interesting. For example, higher-risk fixed income securities, such as non-investment grade bonds and emerging market debt, perform more like equities than government bonds. Therefore, we categorise them under equity-type risk.

The diversifiers category contains assets classes and strategies whose value is influenced by a range of different drivers. They include some ‘alternatives’, which are expected to generate different returns from the underlying assets, such as long/short funds.

Individual diversifiers can display high or low risk in isolation and are not expected to move inversely with equity-type assets in all market conditions: the key is that they have the potential to diversify equity-type risk in periods of market stress. Potential diversifiers must pass a range of tests before we can have conviction in their diversifying characteristics across a range of market environments.

We do not automatically include all assets or strategies traditionally thought of as ‘alternative’. Qualifying diversifiers include precious metals; alternative and targeted return strategies with minimal equity market risk; and unleveraged commercial property and infrastructure funds. Private equity and cyclical commodities do not qualify.

Managing downside risk

Correlation is only one of the criteria we use to screen potential diversifiers. A low or negative downside capture ratio is also attractive. This does not have to be linear: a strategy can have positive upside volatility, but lower volatility on the downside. Similarly, we consider a fund’s track record as well as risk controls, investment parameters and value for money. Some strategies can be more expensive — discretionary macro funds, for example — yet provide good diversification net of fees.

Over the past 18 months, with the end of QE and prospect of higher interest rates, financial markets have been particularly volatile. Surely ideal conditions for diversifiers? Comparing an equally weighted portfolio of our preferred diversifiers to the MSCI World shows:

  • Over the past three years, the MSCI World has gained 29.3% while our diversifiers portfolio is up 15.3%. All strategies within diversifiers contributed positively, but returns were not as good as equities.
  • Over the past year, however, the MSCI World has fallen by 3.4% while our diversifiers portfolio is up 2.3%. The strategies that offered protection in this period have been property, long/short equity and managed futures.
  • Diversifiers offer downside protection (figure 1). The downside capture ratio is around 16%, which is impressive.

These figures suggest LED and our approach to identifying effective diversifiers is working, although we are not complacent and always looking for ways to improve our investment process. However, the process requires significant resources: one of Rathbones’ strengths is the size and capability of our investment research team.

Figure 1: Divisifiers offer protection on the downside (%)
Our divisifiers portfolio has provided protection when equity markets have suffered periods of poor performance.