Diversifying a portfolio by asset class and region offers 'built-in stabilisers' when investing in an uncertain world, says Legal & General Investment Management (LGIM) multi-asset manager Bruce White in this video interview.
Asked by Professional Adviser editor Julian Marr in the above video to consider what constitutes true diversification in today's uncertain markets, White (pictured) points to what he sees as two key characteristics of a multi-asset approach to investing.
The first is what he describes as the "more conventional" method of spreading different types of asset class across different regions. "A well-diversified portfolio should be investing beyond domestic equities and investment grade bonds," he continues.
"It should probably also include high-yield or emerging market debt, say, and different types of debt in the sovereign space such as inflation-linked bonds as well as assets such as real estate."
This "regional dimension", says White, helps investors avoid building up a home bias or too much focus in one specific area. "The beauty of regional diversification is, if there is a crisis or a problem in one particular region, the overall portfolio should be better able to weather the storm," he adds.
Also important, says White, is to consider how best to combine the different asset classes so that they perform well in different environments.
"If you add in an asset class that tends to do better when growth expectations are lowered, such as sovereign bonds, your overall portfolio will be more stable," he explains. "For a portfolio to be genuinely diversified, we believe you have to incorporate built-in stabilisers into its construction."
Asked how a multi-asset approach to investment can help manage volatility, White again offers two angles - the first being the "diversification effect" that comes "ready-made" with a multi-asset fund.
He explains: "Unlike the total return on a portfolio, where you add up the contribution from each different asset class, the diversification effect means portfolio risk is less than the sum of its parts."
The second way a multi-asset approach can help manage volatility, says White, is the way it allows a fund manager to take a holistic perspective - "managing risk over time in reaction or in anticipation of market conditions". "The active management of asset allocation is intended to complement the risk-reducing properties of diversification," he adds.
Turning to risk management tools, White says the LGIM multi-asset team make use of a historical database of asset classes going back to 1973, as well as stress- testing and scenario analysis in the context of their portfolios.
"The database allows an understanding of how asset classes behave in relation to each other, which can be used to assess downside risk in different combinations," he explains.
"What we also do, which is important these days, given the low level of bond yields and interest rates, is readjust that history for what is possible going forward."
Stress-testing and scenario analysis meanwhile help the team think about situations for which history is less of a guide. Using the Brexit vote as an example, White says: "Coming into that, we established vote scenarios, which helped us to position the portfolio both ahead of the EU referendum and also in the aftermath."
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