Portfolios must be diversified within asset classes too

As any savvy investor knows, diversifying one's investments is of utmost importance, especially in a turbulent market.

A diversified allocation is designed to ensure you have easy access to a range of return opportunities amid shifting market conditions.

Diversification does not boost performance - it does not guarantee gains or protect against loss. However, it does allow an investor to set the appropriate level of risk for his or her financial goals and investment horizon.

Knowing how to properly assemble and manage a diversified portfolio of assets, however, is another matter altogether.

It has become especially challenging today, as asset correlation has remained high since the 2008-2009 financial crisis.

Asset correlation is a measure of how two securities move in relation to one another.

Mr Aditya Monappa, Standard Chartered Bank's group wealth management head of asset allocation and portfolio construction, noted that concerns over weak growth in the United States, the European debt crisis, and risk of a hard landing in China have led to deep market fluctuations.

"Within this environment, major asset classes have shown high levels of correlation - for instance, equities and commodities."

This means that price trends in the equity market now tend to move up and down roughly in tandem with those of commodity markets - a phenomenon that began only after the crisis.

Finding uncorrelated asset classes continues to be a challenge today, Mr Monappa said.

Schroders' Asia Pacific head of multi- asset, Mr Al Clark, agreed.

"It is not unusual for asset class correlations to increase in a crisis as markets become driven more by panic than fundamentals," he said.

"What has been unusual this time around is the reluctance of correlations to subside to more 'normal' levels."

With growth in the majority of the developed world below trend, it does not take much for economies to look like they are falling back into recession, he added.

As a result, markets have been oscillating between cyclical upswing and threat of recession.

In this increasingly complex and interconnected world, investors need to be more nuanced in their search for diversification as a broad-brush approach is less effective, Mr Monappa said.

"Simply having a portfolio with some equity and some fixed income will not provide appropriate diversification, because correlation between a number of broad asset classes is quite high."

Investors need to make sure they are diversified within asset classes as well.

Their equity holdings, for example, should include both developed market - US, Europe and Japan - stocks as well as emerging market ones.

And within emerging markets, simply having an allocation to China is not sufficient.

"Emerging market equity exposure should include countries with strong or growing domestic demand rather than those highly dependent on export revenue," Mr Monappa said.

"Another way to access emerging markets is to target investment in strong developed market companies with a significant proportion of their revenues in emerging markets."

This option might be suitable for investors looking to tap into emerging market growth but uncomfortable with the volatility and liquidity issues that arise in certain markets, Mr Monappa added.

As for fixed income, given the explosion of public debt levels in industrialised countries, investors should look at strategic investments in the deepening emerging market fixed income asset class, he said.

Despite the increase in correlations across assets, there still remain several investment options that tend to exhibit lower correlations with risk assets, noted Mr Daryl Liew, the head of portfolio management at Reyl Singapore.

These include cash, high-grade government and corporate debt, and gold.

"Higher net worth investors could also consider having an allocation to alternative investments like hedge funds which can utilise long/short or volatility strategies for instance, which tend to have lower correlations with traditional asset classes," he added.

Even if an investor is comfortable with the mix of assets he has in his portfolio today, his work is not over - a portfolio has to be "rebalanced" regularly.

This is because some assets will increase in value while others might stay the same or fall.

"As a result, the asset that increases in value will form a larger percentage of the overall portfolio. If the asset that increases in value is a risky asset such as equity, then the risk of the allocation will increase," explained Mr Monappa.

"Therefore, it is important to rebalance your portfolio over time to bring it into the appropriate range of risk."

Standard Chartered's 12- month tactical allocation for a moderate risk investor is as follows:

Investment-grade bonds: 25 per cent, with short durations

High-yield bonds: 11 per cent, with a preference for US high-yield bonds

Developed market (US, Europe and Japan) equities: 24 per cent

Asia (except Japan) equities: 14 per cent

Other emerging market equities: 4 per cent

Commodities: 11 per cent, with a preference for base metals over gold

Alternatives: 11 per cent

Reyl's Mr Liew has a similar take. He said a balanced portfolio which would be suitable for a medium-risk middle-aged investor would typically have a 40 per cent allocation to global equities, 30 per cent to global fixed income, 20 per cent to alternatives and 10 per cent to commodities.

yasminey@sph.com.sg

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