Investment theory pioneer Harry Markowitz famously called diversification “the only free lunch in finance” but in reality diversification has been a changing menu over the years and one that will continue to evolve as we move out of the current market cycle. 
Diversification offers investors the opportunity to moderate their risk without sacrificing returns, although Aberdeen Standard Investments’ head of diversified multi-asset strategies Mike Brooks pointed out that this hasn’t always worked out in practice.
“There have been two major equity bear markets this millennium. Most traditional balanced portfolios suffered significant declines during the bursting of the dotcom bubble. Gains from holdings in government bonds were insufficient to offset equity losses,” he said.
“Investors responded by diversifying across a broader range of asset classes and strategies. Yet most multi-asset funds suffered similar declines during the global financial crisis.”
Performance of balanced funds vs global equities in 2008
Source: FE Analytics
Furthermore, the average member of the IA Mixed Investment 40-85% Shares sector (which was previously known as the ‘balanced’ sector) has underperformed the MSCI AC World index by close to 100 percentage points since the end of 2008.
“Today, bond yields across the developed markets are extremely low by historical standards. They offer little protection to investors if inflation picks up. Equity market valuations appear rich, leaving markets vulnerable when this elongated economic cycle finally comes to an end,” Brooks added.
The multi-asset investor said that portfolio diversification will continue to evolve to meet this challenge and has highlighted how it has already changed since the publication of Markowitz’s landmark paper Portfolio Selection in 1952.
While diversification seems to be as old as finance itself – evidence from around 4,000 years ago shows that merchants from Assur, an ancient Mesopotamian city-state, spread their risks across business partnerships – the publication of Markowitz’s Portfolio Selection heralded the era of modern portfolio theory.
“Markowitz’s work provided the mathematical underpinnings for portfolio optimisation,” Brooks said. “It provided investors with a tool to build portfolios situated on the ‘efficient frontier’ – offering the maximum expected return for the level of risk.”
When combined with Bill Sharpe’s 1964 work on the Capital Asset Pricing Model, which looked at how investors would value assets if they followed Markowitz’s recommendations when constructing portfolios, modern portfolio theory was borne. Investors eventually settled on a mix of 60 per cent equities and 40 per cent bonds as being the optimum starting point for investment.
Rolling one-year performance 60/40 portfolio vs global stocks and government bonds
Source: FE Analytics
The next major development came in the 1980s and 1990s, capital controls that had restricted investment flows into overseas markets were abandoned after the end of the Bretton Woods system of fixed exchange rates.
Brooks noted that a combination of deregulation, rapid growth in emerging markets, financial innovation and academic ‘discoveries’ led investors diversifying their portfolios across: domestic and international equities; value and growth stocks; large-cap and small-cap; developed and emerging markets; and government, mortgage and corporate bonds.
The above meant that portfolios were still a blend of equities and bonds but the next evolution – the Yale model – rectified this. Under the leadership of David Swensen, the Yale Endowment generated strong returns in the years running up to the tech bust then staying in positive territory during the bear market – unlike the majority of other investors.
“Investors around the world soon tried to imitate the key differentiating factor of his strategy: exposure to alternative assets,” Brooks explained. “Yale’s alternative assets fell into three categories: absolute return (or hedge funds); real assets (or property and natural resources); and private equity.”
The Aberdeen Standard Investments manager said we are currently in the fourth stage of diversification’s evolution, which was brought in by the global financial crisis of 2008.
One development has been the incorporation of new asset classes and strategies into multi-asset portfolios. Many investors found it difficult to access some of the alternative assets used by the Yale Endowment as these were open to larger institutions.
But mainstream managers now offer funds targeting real assets (infrastructure, property), specialist finance (insurance-linked securities, healthcare royalties, litigation finance) and long/short strategies.
Meanwhile, the current stage of diversification has seen advances in quantitative techniques that provide a better understanding of the underlying drivers of returns and their associated risks.
When it comes to the future of diversification, Brooks believes there are six trends that will reshape how investors build portfolios over the coming years.
First, the shift from public to private markets is set to continue. This could have several impacts, including investors taking more exposure to alternative forms of credit such as direct lending and asset-backed securities.
Secondly, many investors are expected to integrate environmental, social & governance (ESG) analysis into their decision-making process.
Third, investors will also have to pay more attention to emerging markets, which have witnessed rapid economic progress over the past three decades but still make up only 10 per cent of the global financial system.
“Fourth, advances in computer science will allow a more granular analysis of diversification,” Brooks said. “However, quantitative risk models will continue to have their limitations. A qualitative assessment of risk and return will remain vital to achieving effective diversification.”
The fifth trend will be the adoption of a more sophisticated approach to risk management. This will largely be a consequence of the mismatch of assets and liabilities of insurance companies and pension schemes being given more attention as regulatory regimes continue to modernise.
Finally, individuals will increasingly have to take more responsibility for their own financial futures – and the asset management industry can support this by developing diversified solutions to help them achieve this.
“Increased diversification brings increased choice. Benefitting from a more diversified approach therefore requires skill and experience in order to assess this broader range of opportunities,” Brooks concluded.
“This extra effort can be highly rewarding as, if done well, diversification can lead to improved long-term returns delivered in a smoother fashion. Not a free lunch perhaps, but definitely a healthy balanced diet.”