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LGT Investorama: The challenge of diversification

6 luglio 2017

The extremely low interest rate level is an exceptional state of affairs, with investors no longer able to rely on a stable correlation between stocks and bonds. Mixing in alternative investments to a traditional portfolio has several advantages.

The term “correlation” refers to the relationship of the return among various investment categories to each other. If their return rises and falls under the same market conditions, i.e. if they perform in the same way, the correlation is positive. A negative correlation is, however, more important for managing an efficient portfolio. In the best case, the fluctuations of the assets in a portfolio can be completely balanced out if they always act opposite to each other.

In recent years investors were able to benefit from the combination of falling interest rates and rising share prices, which helped lift investments in traditional multi-asset strategies. The flooding of the markets with liquidity provided not only the stock markets with a strong tailwind, but the bond markets also saw an unprecedented demand from buyers, who were not only willing, but practically forced to buy bonds at the highest prices. In addition, the negative correlation between equities and government bonds over the past 20 years has facilitated risk diversification, which also made the traditional mixed funds look good on a risk-adjusted basis. As a consequence, a simple portfolio that invests one half in shares and the other half in government bonds delivered excellent results.

In the coming years, however, the capital market environment will clearly be different from what we have become accustomed to and what is now almost normal. The extremely low interest rate level is an exceptional state of affairs, with investors no longer able to rely on a stable correlation between stocks and bonds. A retreat into bonds does not offer a way out for investors who are no longer comfortable with the risk of equities. In the phase of an upcoming global interest rate reversal, bonds could increasingly entail an unknown interest rate risk for decades. This possibility became evident temporarily in 2015. The positive correlation observed at that time between stocks and government bonds will become more frequent and more pronounced going forward, reason enough to stay vigilant.

In light of the challenges going forward for more efficient diversification, investors should take a closer look at alternative investment classes. To understand this investment class better it helps to change one’s range of vision. Investors expect to be compensated for taking on risks. They receive risk premiums, which are defined as the difference between return and risk-free interest rate. For example, the expected return on an investment in corporate bonds serves to compensate for interest rate, credit rating and liquidity risks. And in line with the previously described market environment, the premiums for equity, interest rate and credit risks are currently rather low.

Alternative investments are based on different risk premiums, with a large part coming from illiquid investment strategies. This includes investments in private equity, real assets, private ILS and some hedge funds. While the purpose, for example, of private equity is to gain an additional illiquidity premium, the goal of private ILS or some hedge fund strategies is to generate absolute returns independent of the markets. Such returns are defined in a mathematical sense as ones that have a slight or even negative correlation to the returns of traditional investment classes, which essentially are stocks and bonds.

Adding alternative investments as a strategic component to a traditional portfolio brings several advantages: First, traditional risk premiums in the current market environment are low. Alternative risk premiums offer the potential for a higher return. Second, the diversification characteristics of bonds are currently being tested. Government bonds, which are deemed to be safe, have become very expensive. Third, traditional portfolios suffer particularly when interest rates rise or equity markets correct. Both scenarios cannot be ignored in light of the 35-year bull market for bonds and the current eight-year bull market for stocks. Fourth, alternative investments can generate positive returns even in market phases when stocks, for example, are trending lower.

The massive interventions of central banks to ward off the danger of deflation have given a lift to both the bond and stock markets and have had an artificial impact on their correlations. The upcoming interest rate reversal, higher valuations on the developed stock markets and geopolitical uncertainty will probably impact the market environment over the coming months, as the conditions for investing solely in the traditional investment classes are not favorable and the demands for efficient diversification are rising. The outlook for returns for alternative investments is affected only to a limited extent in this environment. In addition, the analysis of the risk factors provides insights into the true sources of risk and return of a portfolio. Alternative investments can reduce the cluster risk within a portfolio. The biggest challenge in adding or evaluating alternative investments is overlooking the diverse range of offers. To understand an alternative strategy in detail and to assess its impact on traditional investments correctly requires specialist knowledge. Often the risks of alternative investments are not apparent at first sight, which can lead to misjudgments and disappointments. If the risks are properly assessed, higher returns and better diversification can be achieved.

Antonio Ferrer
Portfolio Manager Princely Strategy

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