The fast view
- Diversification has long been a core component of balancing the risk of a portfolio, with the traditional attributes of government bonds making them the go-to asset for many investors.
- These attributes have now changed; previously attractive yields have plummeted, there is little value present and their traditional negative correlation to equities – and lower volatility – have become notably unstable.
- ‘Reaching for yield’ is not necessarily the answer, as moving down the credit spectrum can expose investors to greater risk, both in terms of the individual asset and the greater correlation to equities, which can compound losses in periods of drawdown.
- While these points have been debated for some time, the COVID-19 pandemic has accelerated these trends and investors are set to experience greater levels of uncertainty in the coming years, in our view.
- We think this environment supports the case for making an allocation to defensive strategies such as Ninety One’s Global Multi-Asset Income Fund. Since inception, its consistent and sustainable yield of c.4% and low beta profile, driven by bottom-up security selection and a multi-pronged approach to risk, has delivered risk-adjusted returns in excess of traditional safe haven assets with significantly lower volatility.
What is diversification and why is it important?
Diversification is based on the concept of holding a mixture of assets that react differently to the same economic event, thereby reducing the risk of suffering a meaningful drawdown at the portfolio level during times of market stress. Most clients are eager to mitigate large equity market drawdowns, the most recent example being in March 2020, and it is government bonds that have typically served as effective portfolio diversifiers – not just because of their solid returns, but crucially their low volatility and often negative correlation to equities. The value of government bonds typically increases as equities decrease, and these defensive, diversifying qualities have ensured their place in investor portfolios to counter equity market weakness.
However, today’s environment is markedly different to historical norms. The three core drivers of bond diversification in portfolios – yield, value, and correlation – are either deteriorating or, at best, increasingly uncertain. As such, we doubt their ability to counterbalance material equity declines as effectively in the future – a quandary for investors who allocate capital to both equities and sovereign bonds. So what precisely makes these three drivers effective diversifiers, and what is preventing government bonds from doing their traditional job?
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The cash conundrum
Specific risks
Currency exchange: Changes in the relative values of different currencies may adversely affect the value of investments and any related income. Default: There is a risk that the issuers of fixed income investments (e.g. bonds) may not be able to meet interest payments nor repay the money they have borrowed. The worse the credit quality of the issuer, the greater the risk of default and therefore investment loss.
Derivatives: The use of derivatives may increase overall risk by magnifying the effect of both gains and losses leading to large changes in value and potentially large financial loss. A counterparty to a derivative transaction may fail to meet its obligations which may also lead to a financial loss.
Emerging market (inc. China): These markets carry a higher risk of financial loss than more developed markets as they may have less developed legal, political, economic or other systems.
Equity investment: The value of equities (e.g. shares) and equity-related investments may vary according to company profits and future prospects as well as more general market factors. In the event of a company default (e.g. insolvency), the owners of their equity rank last in terms of any financial payment from that company.
Government securities exposure: The Fund may invest more than 35% of its assets in securities issued or guaranteed by a permitted sovereign entity, as defined in the definitions section of the Fund’s prospectus.
Interest rate: The value of fixed income investments (e.g. bonds) tends to decrease when interest rates rise.
All investments carry the risk of capital loss. The value of investments, and any income generated from them, can fall as well as rise and will be affected by changes in interest rates, currency fluctuations, general market conditions and other political, social and economic developments, as well as by specific matters relating to the assets in which the investment strategy invests. If any currency differs from the investor’s home currency, returns may increase or decrease as a result of currency fluctuations. Past performance is not a reliable indicator of future results.
