Industry Voice: The benefits of diversification

Ken Scott, Head of Investment Solutions at Royal London, explains how their approach to diversification aims to strengthen resilience.

clock • 4 min read
Ken Scott, Royal London
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Ken Scott, Royal London

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. Holding a broad mix of assets offers resilience and gives fund managers tactical opportunities to deliver positive risk-adjusted returns.

Our process

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. As part of this design process, portfolios are optimised on a set of assumptions, and a series of alternative economic scenarios. This ensures they maximise expected risk-adjusted returns and strengthen resilience to market shocks.

While a portfolio holding just one asset class may deliver superior returns in certain market shocks - 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 others. While a simple portfolio can produce strong returns in one set of market conditions - as a 60/40 portfolio did while rates reduced in the 2010s - market conditions can turn quickly. So it's important portfolios are positioned to be resilient to shifts.

Broadly diversified portfolios

Combining a broad mix of assets, helps us improve resilience of the portfolios to various shocks, providing a smoother investment journey. In our drawdown portfolios - the Governed Retirement Income Portfolios (GRIPs) - this is done with a focus on reducing downside risk.

While increased diversification could mean we forgo superior upside in one shock event, we believe the long-term benefit of improved risk reduction outweighs any short-term relative loss. It's this balance that necessitates an in-depth analysis of each asset class, each portfolio those assets support, and possible future scenario (see table below)

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.

This table shows Governed Portfolio (GP) 5, one of our balanced risk portfolios. Higher-risk portfolios have performed strongly in the long-term, but with more ups and downs.

 

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 to provide greater protection from inflation risk - particularly beneficial with the onset of the Ukraine Russia war.

We 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 - skewed heavily towards 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, they're less likely to offer protection if interest rates continue to rise over the medium term.

The chart below highlights the benefits of diversification, comparing Governed Portfolio 5 with a typical 60/40 balanced fund - this broader mix should provide more resilience during bouts of volatility.

Our strategic equity mix

Many funds, including simple balanced portfolios, invest in equities on a market capitalisation basis. We allow for additional factors like relative valuations of different markets.

Market capitalisation equity indices are heavily biased towards the US market: a market heavy in ‘growth' stocks - in sectors like technology where 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, giving 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. Their value tends to be more predicted on shorter term profits so is 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 (chart below) and further aids portfolio resilience.

The 40% in a 60/40 fund is heavily weighted to UK and invested in UK government bonds (gilts). By contrast, our portfolios boast other diversifying assets including property, commodities and high-yield. Within the UK bonds space, we spread the investment between gilts, index-linked bonds, and corporate bonds

Diversification in this environment

With the difficult market environment ahead, the diversification's importance 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.

 

This post is funded by Royal London

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