Despite equities and bonds recently both falling you should still diversify your portfolio
Bonds still have a useful role in lower-risk investors portfolio and more recently have offered attractive yields
Alternative investments have not necessarily mitigated downside but some of these are now on more attractive valuations
Diversifying your portfolio is widely accepted as a key way of mitigating downside. At a very broad level, this has involved holding a mixture of equities and bonds, as their prices largely did not move together. But more recently both equities and bonds have sold off and been more highly correlated.
However, Rob Morgan, chief analyst at Charles Stanley, says: “We have seen an atypical period where bonds and equities have been correlated, both subject to the negative trend of rapidly rising interest rates. There have been previous periods where this has happened, but it is more usual for these asset classes to exhibit diversification benefits – and that could well be the case going forward. The benefits of diversification should start to reassert themselves as inflation peaks and interest rates start to fall away. At this point bond markets should start to provide some protection versus equities as investors worry about the possibility of a long recession. Correlations change over time, but principles of diversification remain. The traditional 60/40 [equity/bond split] portfolio has been through an exceptionally difficult period with a rapid adjustment to higher inflation but there is reason to believe that it is now in a good place. This principle was suspended during an era of very low interest rates but that is coming to an end.”
It is still very important to diversify your portfolio and now in particular to diversify within each broad asset class you hold to mitigate the effects of bonds and equities moving in line with each other. Investors holding assets concentrated in certain sectors, or stocks that are particularly sensitive to rising interest rates and a faltering economy, are most likely to be negatively impacted.
For example, Rachel Winter, investment manager at Killik & Co, categorises equities into three broad categories and ensures that client portfolios have a good mixture across all three. The categories are: fast growth, for example, technology stocks; defensives such as consumer staples and healthcare; and cyclicals such as banks.
Winter also aims to have a good mix of exposures across different equity sectors. If you have too much in the same area the value of your portfolio could be very volatile. For example, some investors are over exposed to technology stocks because they have been attracted by their strong returns and or because of strong growth tech stocks might unintentionally have become a larger part of portfolios. But more recently tech stocks have fallen sharply.
As interest rates rise equity and bond prices are likely to come down. Winter suggests investing in companies which can withstand higher interest rates, for example, ones with good levels of growth, strong balance sheets, and no or low levels of debt. These are more likely to be able to withstand a period of lower revenues, and higher borrowing costs and raw material prices.
Large international companies are often well capitalised, while smaller and unlisted companies tend not to be as strong. But smaller companies can also help to diversify growth portfolios, if you have a high enough risk appetite and long enough investment horizon to invest in them. And there are always exceptions so it is important to know a company’s strength before investing in it or avoiding it – whatever its size.
Andrew Rees, investment manager at EQ Investors, also suggests diversifying by equity style. This could mean holding both quality growth stocks and reliable dividend-paying companies, or value as well as growth stocks. Funds which offer exposure to quality growth stocks include Lindsell Train Global Equity (IE00BJSPMJ28) and funds which offer exposure to value stocks include Jupiter Global Value Equity (GB00BF5DRJ63).
You should diversify equity exposure geographically. For example, a portfolio with large positions in UK equities, sterling denominated bonds and UK domiciled infrastructure funds could at the moment be susceptible to a political miss-step, argues Rees. And as you probably also own a home in the UK, and earn income or pensions payments in sterling, you shouldn’t have to much of a home bias in your investments.
By contrast, investors holding US assets or ones of which the returns are denominated in US dollars have benefitted from the strength of this currency this year. But this is not always the case –- a reason portfolios should not be over exposed to any one currency.
Conversely, you should not over diversify because the contribution each investment makes will have less of an impact on your portfolio’s overall return and it could generate a return similar to that of a market tracker fund. But instead of paying for one low cost fund, you would pay the charges and trading fees of several funds and investments, and these would detract from your return.
If you have many investments it is also hard to have a good knowledge of and follow each one, and doing this is extra important in the current market environment.
Alternatives
Because of the increase in the correlation between equities and bonds, investors have increasingly turned to alternative assets such as property, private equity and infrastructure, which can deliver different return patterns to mainstream investments. But these have not necessarily held up better than equities and bonds over the past few months so Winter argues that there is not a greater case for them in current conditions. A problem for private investors in particular is that they cannot buy these assets directly so have to invest in them via investment trusts which are listed on the stock market. This means that even if the prices of the underlying assets are less volatile than stock markets, the share prices of the investment trusts may move in line with markets.
However, Winter thinks that property has become more attractive now because of the sell off, and invests more of the cautious portfolios she runs in this asset and infrastructure.
For example, real estate investment trust (Reit) LondonMetric Property‘s (LMP) share price has been on a downward trend since December last year and fallen particularly sharply since July this year. But its holdings, on average, have an unexpired lease term of 12 years and occupancy of 99 per cent. It lets its assets such as warehouses to large companies, and LondonMetric Property’s tenants include Primark, Amazon.com (US:AMZN) and Argos.
Morgan, meanwhile, highlights LXI REIT (LXI) which lets or pre-lets UK properties on very long (typically 20 to 30 years to first break) inflation-linked leases, to strong tenant covenants across a range of property sectors. These include industrial properties, hotels, and healthcare and leisure premises and LXI REIT’s tenants include Travelodge, Premier Inn, Aldi and Starbucks.
But Winter would only access property via closed-ended listed funds because open-ended property funds can stop investors taking their money out for periods of time if they cannot sell assets quickly enough to pay the redemptions. For example, this has recently happened to property funds run by Columbia Threadneedle. You sell your shares in listed property funds on the secondary market rather than back to the fund, so this problem does not arise. But in times of stress you may have to sell your property trust shares at a much lower price and wider discount to net asset value than you bought them at. So it’s important to have a long term investment horizon if you invest in listed property funds.
Asset allocation examples
Morgan favours taking a core and satellite approach to portfolio construction. This involves having most of your assets in mainstream investments such as major market equities and bonds, and some smaller allocations to ‘satellites’ – specialist investments such as smaller companies equities, property, private equity and infrastructure funds. “A core fund, for instance, might represent 10 per cent of a portfolio, and a satellite around 2 per cent to 5 per cent, though that’s just an example,” he explains. “How the principle is applied varies according to your portfolio’s size and strategy, and the nature of its components.”
Morgan says that an example of a portfolio allocation for a high risk, long term growth investor could be as follows:
| Asset | Allocation range (%) |
| Equity | 80-90 |
| Fixed Interest/tactical cash | 5-10 |
| Alternatives | 5-10 |
Ward, meanwhile, suggests looking at the MSCI PIMFA Private Investor Index Series as guide to how you might asset allocate a portfolio, though the exact amounts in each area depend on your own personal specifications. For example, at the moment, the MSCI PIMFA Private Investor Growth Index has the following allocation:
Morgan says that an example of a portfolio allocation for a cautious, wealth preservation investor could be as follows:
| Asset | Allocation range (%) |
| Equity | 30-50 |
| Fixed Interest/tactical cash | 20-40 |
| Alternatives | 10-30 |
Courtiers Total Return Cautious Risk Fund (GB00B1P2K418), meanwhile, cannot invest more than 60 per cent of its assets in equities, and James Timpson, deputy fund manager at Courtiers, says that because of market volatility it is currently closer to 50 per cent. It also holds infrastructure assets, short dated bonds and zero dividend preference shares to maximise diversification.
For mainstream global equity exposure, Morgan suggests Fidelity Index World (GB00BJS8SJ34) – a cheap passive tracker fund and or M&G Global Dividend (GB00B39R2R32). For regional equity exposure he highlights BlackRock European Dynamic (GB00BCZRNN30), Brown Advisory US Sustainable Growth (IE00BF1T6V32), Premier Miton US Opportunities (GB00B8278F56), Liontrust Sustainable Future UK Growth (GB0030028764), TB Evenlode Income (GB00BD0B7D55) Invesco Asian (GB00BJ04DS38) and Stewart Investors Asia Pacific Sustainability (GB00B0TY6V50).
For bond exposure, you could use some of the funds highlighted above. And wealth preservation and alternative asset exposure could include Ruffer Investment Company (RICA), iShares Physical Gold ETC (SGLN), HICL Infrastructure (HICL), Renewables Infrastructure Group (TRIG), and the property funds highlighted above.
