Why bother with global diversification, when different asset classes from different parts of the world seem to have become so highly correlated that they rise and fall on positive and negative news in almost perfect synchrony?
Global diversification has been a commonly accepted portfolio mantra for many advisors and clients because it traditionally promises better returns with less volatility than a domestic-only portfolio over time. Over the past few years, that premise has been challenged by less-than-satisfying results on both accounts.
First, investors remain scarred by the global financial crisis, when the correlation of all asset classes went to 1. Second, global growth has sputtered and been inconsistent, while important parts of the financial system remain fragile. One example of that fragility arises from Brexit, as the formal process of the U.K. leaving the European Union — which has already prompted more pan-European volatility — has not even begun yet.
Central banks, whose policy heavy-handedness has been one of the main challenges to global diversification and the driver of the frantic search for yield, remain active. Those central bankers are acting not just through policy measures that diverge from country to country, but as market participants themselves, purchasing assets beyond government bonds in a way that’s never been seen before.
With the U.S. stock market having been the top performer worldwide, it’s only normal that many investors would rather stay put domestically than look at the broader world — a world that is arguably much flatter than it’s ever been. The flat world itself makes it tougher to find non-correlated investments.
But for multi-asset fund managers, ferreting out the best opportunities from around the globe and combining them for optimal portfolio performance is still as valid an endeavor as it is exciting.
“The rising correlation between asset classes has challenged” the traditional benefits of diversification, said Maya Bhandari, director of multi-asset allocation at U.K.-based Columbia Threadneedle Investments, “but we have also seen in the last few years that spreading risk across different asset classes has provided some important benefits.”
Bhandari said that some of the funds she co-manages are “free of benchmarks. We really start with a blank sheet of paper, asking ourselves ‘What asset classes do we own, and how do they fit’” into the overall portfolio?
In a highly correlated world, judging how best to combine different asset classes has become a much more nuanced process. It also requires a certain degree of willingness to go against the grain and dig deeper into the fundamentals beneath mass-market swings to find opportunities. It also calls for making portfolio decisions quickly.
“Last year, partly based on the results of monetary policy, we built up a position in European high-yield bonds,” said Bhandari. “Following that, we saw a blowup in oil prices that impacted U.S. high-yield, and with good reason,” since 18% to 20% of the high-yield bond index is energy companies. However, European high-yield “was also a casualty, the spread widening there purely a result of the contagion effect. We saw European high-yield as offering value and we built our position up to 15%” of Columbia Threadneedle’s Global Multi Asset Income Fund, “which has served us well.”
Heading into the final part of this year, what are the trends advisors and investors should be looking out for, and how will they influence global diversification? Where do the opportunities for global diversification lie?
Investment Advisor spoke to some proponents of global diversification to get their take.
Consider, but Don’t Necessarily Follow, the Central Banks
In July, the Bank of England cut interest rates, while speculation is growing that the Federal Reserve will raise rates before year end (we went to press before the FOMC’s September meeting; the Fed’s policy-making arm meets again after the election, in December). The European Central Bank (ECB) and Bank of Japan have been buying corporate bonds, and now the Bank of England is going to do the same.
Through the years, central bank policies have supported markets in various ways and provided the kind of stability that calmed frightened investors. Central banks are such key players in the financial system and the markets — to the consternation of many investors — that for many it has become de rigeur to monitor the banks’ movements and factor them into their investment approach.
But now, after so many years of central bank involvement and divergence among central banks’ policies, investors like Daniel Kern, chief investment strategist at TFC Financial Management, think the wiser option would be to not follow every move by every central bank.
Kern believes that investors should evaluate central bank moves carefully for the effect that they are likely to have, and decide not to follow those moves if it makes greater sense for their overall portfolio.
“Expectations are an important factor to consider when deciding whether to invest following central bank intervention,” he said.
ECB president Mario Draghi’s “Whatever it Takes” speech in July 2012 eased concerns about a potential breakup of the eurozone, and provided policy support for a stock market rally in the zone. It was the kind of intervention that sent a positive signal for investors, and an example that supported following central bank intervention into the markets. However, “a recent example of when not to follow central bank intervention comes from Japan, as the Bank of Japan has repeatedly disappointed the market,” Kern said. “Imposition of a negative interest rate policy hasn’t achieved the desired objectives, and subsequent policy statements have fallen short of expectations.”
Watch for a Shift From Monetary to Fiscal Policy
It may seem counterintuitive, but Paul O’Connor, co-head of the multi-asset team at Henderson Global Investors, is of the view that monetary policy may be reaching its limits globally.
In some countries, he said, central banks are running out of assets to buy, while in other countries low interest rates and therefore bond yields are beginning to have adverse impacts on pension funds, banks and insurance companies. Overall, O’Connor believes that the benefits of additional monetary easing are diminishing while the costs are rising.
“Against this backdrop, a consensus is emerging that fiscal policy will have to play a bigger role in stimulating the global economy, if that is needed,” he said. “At this stage, with the global economy continuing to recover, governments are only shifting very modestly in this direction, but after five years of global fiscal tightening, 2016 looks like [it will be] the first year since 2010 in which fiscal policy will boost growth.”
To that end, Japan has announced a major fiscal expansion, the U.K. government is rowing away from its previous austerity program and both candidates for the U.S. presidential election have, O’Connor said, built their campaigns around proposed fiscal expansions.
“At this stage, the collective impact of the proposed global fiscal easing is still fairly modest,” according to O’Connor, but “the move away from austerity has begun, and a more decisive fiscal response is likely if growth falters.”
To Loosen Correlations and Bring Back Growth
“Paradoxically, the worst economic numbers gave rise to the best policy reactions, which in turn overshadowed growth,” O’Connor said. “But now, as policy becomes weaker, I think growth will become a bigger factor for valuing diversification opportunities, and that will bring us back to a more normal market environment as it diminishes the frantic search for yield.”
While the influence of monetary policy on financial markets appears to be peaking, both economic and political factors are beginning to reassert themselves as important factors when seeking investment opportunities. This in turn will ease the high cross-asset correlations across markets, O’Connor said, “and it should mean that multi-asset investors have more opportunities for finding diversification as assets become more influenced by idiosyncratic factors and less driven by central banks.” He also argued this dynamic could create an environment in which active managers will find more opportunities to add value in both asset allocation and stock selection.
A renewed focus on such factors as growth, productivity and demographics, on transparency, governance and the rule of law, would also make sense in the context of current equity market valuations, not least with respect to the U.S. stock market, said Ben Rozin, senior analyst and portfolio manager at Manning & Napier Advisors. The U.S. market stands out as being much more expensive than the rest of the world, even as economic growth here has slowed; whereas in parts of the globe where growth is stronger and there are opportunities for more growth, valuations are cheaper and look more attractive.