Portfolio diversification is paying off again, rewarding volatility-weary advisers with higher, more stable returns and lower risk, according to the latest quarterly Portfolio Clarity Trends Report published by Natixis Global Asset Management.
The most broadly diversified investment portfolios performed best for the period ending June 30 2016. Diversification levels rose, largely because of increasing usage of alternative strategies, which reached a three-year high in the second quarter.
“The trends we’re seeing suggest the return of more traditional market dynamics, where investors are rewarded with enhanced returns for taking diversified risks,” says John Hailer (pictured), CEO of Natixis Global Asset Management for the Americas and Asia. “Prior to the third quarter of 2015, investors generally were taking on more risk to achieve higher returns, and many got hurt when the recent sharp, episodic bouts of volatility hit the markets.”
The average moderate-risk model portfolios analysed by Natixis gained 2.1 per cent in the second quarter, outperforming the average retail portfolio, which grew 0.5 per cent, and holding their own against the S&P 500, which gained 2.5 per cent.
Despite limited exposure to high yield bonds and international stocks, the strong relative performance of moderate model portfolios benefited from a diverse mix of alternative strategies and fixed-income investments. The greatest diversification drivers in the second quarter were managed futures, gold, market-neutral strategies and long-duration government bonds.
US advisers continued to favour domestic over international stocks and equity concentration has remained high, contributing to 92 per cent of overall portfolio risk. However, investment professionals began broadening portfolio diversification when volatility picked up in earnest last August. They are now allocating more of their client assets to alternatives and to a greater variety of alternative strategies within the allocation, which helped lessen the severity of equity market drawdowns for the most diversified portfolios over the past year.
Natixis found that portfolios well positioned ahead of plummeting oil prices and global growth concerns in early 2016 and the Brexit vote in June fared better and proved more resilient to market aftershocks than those that diversified reactively or sporadically.
From the market peak on 18 August 2015 through 30 June 2016, returns by the most diversified, best-performing portfolios in the top quartile grew 2.7 per cent, exceeded the bottom quartile by 340 basis points.
In the second quarter, the average moderate-risk portfolio in the study had 52.7 per cent of assets in stocks, down from 54.8 per cent for the same period a year earlier. Average allocation to US equities was 35 per cent compared to 14 per cent for international. The high concentration of domestic equities is a reflection of the strong relative performance of the S&P 500 over the past several years and due, in part, to a lack of compelling opportunities in other asset classes.
Bond allocations, having bottomed out last year on the prospect of higher interest rates, ticked up 3 per cent in the second quarter to 30 per cent of holdings. Exposure to intermediate term bonds rose to 11 per cent – or about 36 per cent of the typical bond portfolio – on the prospect of interest rates remaining low. Municipal bonds (all types) accounted for 8 per cent of fixed income allocations.
Allocations to alternatives increased to 8 per cent on average, across all portfolios, up from 6 per cent as of the end of the second quarter last year. Of the 66 per cent of portfolios using alternative funds, the average weight was 11 per cent. Another 5 per cent of the portfolios were in allocation funds, while the remaining allocations were split among cash, real estate investment trusts (REITs) and commodities.
The best-performing portfolios – those in the top quartile of those analysed by Natixis – had these factors in common:
• Lower allocations to equity (45 per cent in the top quartile vs. 62 per cent in bottom quartile)
• Higher allocations to fixed income and alternatives (33 per cent and 11 per cent allocated to fixed income and alternatives, respectively, for the top quartile vs. 24 per cent and 5 per cent for the bottom quartile)
• Notably higher allocations to intermediate term bonds and managed futures
• Diversification benefits of 25 per cent. A telling measure of the percentage of risk diversified away due to low correlations between holdings, the diversification benefit among top quartile portfolios was more than 10 percentage points higher than the bottom quartile portfolios.
“Diversification matters,” says Marina Gross, executive vice president of Natixis’ portfolio research and consulting group. “In an environment distinctly lacking in precedent and visibility, diversification may be one of the best defences an asset allocator has.”