We recommend they spread their risks by investing in a range of assets with high yield potential but low correlation with each other. What drives returns for one will be different to what drives returns for another.
It can help to smooth portfolio returns and offer downside protection in times of stress. It’s what we call genuine diversification. Yet so few investors do it well, if at all.
Diversification is not just about lowering risk. It is about improving risk-adjusted return. In a volatile environment – which is what we anticipate as we look ahead – what investors will crave is reliability of return. To achieve it, they need to be selective.
There are assets that generate income potential irrespective of whether an economy is growing or a market is falling. The skill is combining them in a single portfolio.
We know that stocks can be fickle. Their prices are subject to a myriad of influences out of their control. High-quality companies delivering strong earnings year after year can still see their stock prices punished.
Still, investors can prioritise profitable companies with a track record of paying dividends. These regular payments contribute to total return and can help to mitigate against downturns.
When it comes to risk-adjusted returns, one asset class we like is emerging market debt. It accounts for just 5 per cent of global investor portfolios on average – even though the asset class accounts for 25 per cent of all outstanding debt globally.*
But these unloved bonds continue to deliver comfortably higher potential yields and lower default rates than developed market peers. They have displayed far lower volatility historically than equities, too.
We see the brightest prospects in local currency bonds, which offer both strong relative yield and investment grade credit quality. They showcased their resilience and independence by outperforming strongly during the market slumps of 2008 and the fourth quarter of 2018.
Exploring alternatives
Investors seeking to diversify should also consider alternative assets whose prospects are less closely tied to economic conditions than mainstream stocks and bonds. Such assets tend to be less impacted by market volatility and, as such, can help to improve portfolio diversification.
Investors can access them through vehicles listed on exchange. They are similar to real estate investment trusts (REITs) but offer a range of underlying assets beyond just property. They have the benefit of being less susceptible to sell-offs, too, because they’re seldom held in professional equity managers’ portfolios.
For example, there are companies investing in a range of infrastructure assets that provide steady, inflation-linked returns. Many infrastructure projects are integral to local development initiatives and benefit from state subsidies, including social infrastructure (hospitals, schools), core infrastructure (transport assets) and renewable infrastructure (wind farms, solar parks).
The fact these assets often rely on government-sourced contracts makes them more dependable than residential and commercial property sectors, where demand is more closely correlated to economic growth.
There are also a range of niche investment opportunities that provide income independent of economic conditions. This includes firms that earn a steady income from financing the cost of bringing commercial litigation cases to court. They choose cases with the best chances of winning, since they earn a percentage of awards handed to successful claimants but bear the cost of unsuccessful cases. This segment has low correlation to other asset classes.
Further, there are companies that create pooled investment funds to buy aircraft and lease them back to airlines. Lease agreements provide a regular income stream. Although the cost of buying aeroplanes can leave them exposed if air travel drops, we think the industry is well supported by the rising wealth of emerging economies.
Above we list just a few investment opportunities with long-term income characteristics and low correlation to economic cycles. By combining them, investors can create a portfolio better placed to withstand the sort of volatility we expect to see in coming years. By that time, we suspect reliability of return will be at the forefront of investors’ minds.
Mike Brooks, head of diversified assets, Aberdeen Standard Investments
