The benefits of diversification
Ken Scott, Head of Investment Solutions at Royal London, explains how our approach to diversification aims to strengthen resilience and target opportunities across a wide range of asset classes.
Why broad diversification is important
The principal of broad diversification is at the core of our multi-asset portfolios. The performance of each asset class varies with economic environments; and different asset classes will perform better in any given environment. Therefore, holding a broad mix of assets offers resilience and gives our fund managers more tactical opportunities to deliver positive risk-adjusted returns for your clients.
The Governed Range consists of 14 risk-graded, multi-asset portfolios designed to suit your clients’ appetites to risk; whether they’re still saving or accessing their savings; and how long their savings will be invested for.
Each portfolio benefits from a strategic asset allocation (SAA) - a core range of assets designed to deliver above-inflation growth over the medium to long-term (see Chart 1).
As part of this design process, portfolios are optimised on a central set of assumptions, as well as a series of alternative economic scenarios. This ensures they maximise expected risk-adjusted returns and strengthen resilience to potential market shocks.
While a portfolio holding just one asset class may deliver superior returns in one type of market shock - e.g. a pure government bond fund during the deflationary Covid shock - it’s unlikely to be the same assets that will fare well in other types of shock.
And while a simple portfolio can produce strong returns in one set of market conditions – as a 60/40 portfolio did while rates were reducing in the 2010s – market conditions can turn quickly. So it’s important that portfolios are positioned to be resilient to these shifts.
Broadly diversified portfolios
Combining a broad mix of assets, helps us improve resilience of the portfolios to various types of shocks and provide a smoother investment journey for your clients. In our drawdown portfolios – the Governed Retirement Income Portfolios (GRIPs) – this is done with a specific focus on reducing downside risk.
While this increased diversification could mean that we forgo superior upside in one shock event, we believe the long-term benefit of the improved risk reduction outweighs any perceived short-term relative loss.
It’s this delicate balance that necessitates an in-depth analysis of each asset class, each portfolio those assets support, and each possible future scenario.
This can be seen in Chart 1. While our multi-asset mix is never the best performing asset class by design, it’s never the worst, aiming instead to provide a smoother investment journey for clients.
The table shows Governed Portfolio 5, one of our balanced risk portfolios. Higher-risk portfolios have performed more strongly in the long-term, but have had more ups and downs along the way.
Chart 1: Annual asset class returns (in GBP)
Broad diversification and resilience
We believe the asset allocation within our Governed Range is much broader than our main competitors. For example, we include commodities and commercial property within our portfolios to provide greater protection from inflation risk. This has been particularly beneficial over 2021 and start of 2022 with the onset of the Ukraine Russia war.
We also think carefully about diversification within each asset class. For example, sectoral diversification typically offers more resilience than geographical diversification in equity markets.
Traditional 60/40 balanced funds invest 60% in equities, with that 60% skewed heavily towards the US markets which dominate the global stock-market weightings. These funds performed well over the last decade of low inflation and falling bond yields. However, these same funds are less likely to offer meaningful protection going forward, especially if interest rates continue to rise over the medium term.
Chart 2 below highlights the benefits of diversification, by comparing Governed Portfolio 5 with a typical 60/40 balanced fund – for the same level of risk, a higher investment return can be achieved.
Chart 2: A broadly diversified asset mix
Our strategic equity mix
Many funds, including simple balanced portfolios, invest in equities on a market capitalisation basis. However, we allow for additional factors like relative valuations of different markets.
Market capitalisation equity indices are heavily biased towards the US market: a market that’s heavy in ‘growth’ stocks – in sectors like the technology sector where the value’s based on future potential – and generally considered one of the most expensive equity markets globally. Our strategic equity mix recognises this and reduces exposure to this region, instead, giving a greater weight to more attractively valued UK equities. UK markets are more weighted towards ‘value’ stocks – i.e. stocks from sectors such as utility and financial companies. The value of these stocks tends to be more predicted on shorter term profits and is therefore more resilient to changes in inflation and interest rates.
This gives the Governed Range more of a value tilt than standard global indices, reducing reliance on a few expensive and interest rate sensitive growth sectors to generate returns (see Chart 3) and further aids portfolio resilience.
The 40% in a 60/40 fund is typically heavily weighted to UK, and within that, invested in UK government bonds (gilts). By contrast, our portfolios boast a range of other diversifying assets including property, commodities and high-yield; and, within the UK bonds space, we spread the investment between gilts, index-linked bonds, and corporate bonds.
Chart 3: Sector weightings in the Governed Range and passive balanced funds
Importance of diversification in this environment
With the difficult market environment ahead, the importance of diversification can’t be understated. While less diversified funds, with high concentration to certain assets and sectors have benefitted in a disinflationary environment, this year’s shown the value of a truly diversified approach.
The Governed Range offers clients the benefits of broad diversification to enable a smoother journey towards, and through, retirement.
Our investment toolkit is designed to help you recommend the Governed Range and have regular, ongoing investment conversations with your clients.