Portfolios must be diversified within asset classes too

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.

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