It’s perhaps the most hackneyed finance-related cliché, but diversification being the only free lunch in investing has rarely been as important a concept as it is now – a time when stock markets are more concentrated than they’ve been for 40 years or more.
The 10 biggest companies in the S&P 500 index account for 36% of the index. The last time we saw anything like this kind of concentration was in the early 1970s.
That was the era of the so-called Nifty Fifty, a group of 50 companies believed to be the best and fastest-growing companies in America. As Howard Marks recalled in a 2021 letter, these were companies so good that “nothing bad could happen to them” and “there was no price too high” for their shares.
Today, there’s a similar phenomenon going on. Investors are piling into companies so good that nothing bad will happen to them and there is no price that is too high to pay for their shares. Only this time around, there aren’t 50 of these companies, there’s seven.
Nvidia on its own is up 223.6% in the space of 12 months, over 400% in the space of 18 months and more than 1,000% in the past 24 months. That’s a large part of the reason why the S&P 500 remains at or around a record high.
Now, I won’t speculate on what will happen to the Magnificent Seven over the course of the next 12, 18 or 24 months. I will, though, let Marks remind you that the Nifty Fifty all suffered huge share price declines between 1972 and 1974.
“Thanks to the crash, they showed negative holdings-period returns for many years. Their dismal performance cost me my job as director of equity research,” Marks said.
Now, the caveat, of course, is that many (Marks reckons about half) of the Nifty Fifty became household names (think McDonald’s, Coca-Cola and Procter & Gamble). Evidently, those very high valuations were justified given a long enough time horizon.
In reality, very few people have the kind of time horizon needed to stick by even the best of companies when their wealth is being wiped out in real time.
This is a rather long-winded way of suggesting that perhaps some diversification away from equities is worth considering.
Even the International Monetary Fund (IMF) warned recently that there was a “widening disconnect” between escalating geopolitical tensions and low levels of market volatility. Monetary policy easing could fuel asset price bubbles and markets are underestimating risks posed by military conflicts and impending elections, the IMF said.
In this context, perhaps it’s worth looking around for investments that can provide sources of returns that are uncorrelated to equity markets.
Bonds are one popular option here, but while they offer risk-free returns, the equity/bond correlation is unreliable. The persistently negative equity/bond correlation has been a recent phenomenon. From the end of the Bretton Woods era and the start of the new millennium, bonds and equities were positively correlated, data from Schroders shows.
Investment trusts are another option. The investment company wrapper gives retail investors exposure to uncorrelated asset classes favoured by sophisticated or institutional investors. These can include hedge funds, infrastructure or impact assets.
BH Macro is the only London-listed investment company offering exposure to a diversified macro hedge fund. It seeks to produce compelling, asymmetric returns, independent of the market environment and with low correlation to risk assets.
BH Macro invests exclusively in the Brevan Howard master fund, giving it exposure to a variety of asset classes, with a primary focus on global fixed income and foreign exchange but also peripheral exposure to other asset classes, such as equity, credit, commodities and digital assets.
Data shows that BH Macro has a structurally low correlation to equity markets. Note that its correlation to equities is not negative – it’s not necessarily the case that the fund suffers when equities perform well. Indeed, BH Macro has only suffered three individual years of negative aggregate net asset value (NAV) performance since IPO in 2007.
Within infrastructure, the diversified portfolio of low-risk availability-based assets, coupled with largely fixed-rate debt at an asset level owned by BBGI Global Infrastructure has contributed to a steadily increasing NAV performance of 43.7% over five years alongside increasing income that flows through to strong dividend increases.
BBGI generally offers higher levels of downside protection and diversification than other ‘real asset’ trusts, which tend to be more UK-focused.
Greencoat UK Wind falls into the UK-focused real asset bucket, but it has a clear and well-defined approach of investing in wind farms up and down the country. On a discount of 16% and with a yield of almost 7.5%, its potential total returns are attractive, even more so if shares re-rate. A colleague recently ran the numbers and found that Greencoat UK Wind had a negative correlation to the MSCI World index.
For those wanting to do some good with their uncorrelated investments, Schroder BSC Social Impact is worth a second glance. Its assets include social and affordable housing projects for vulnerable people, as well as providing capital for charities and social enterprises working with disadvantaged.
The rents gained from the housing assets have very little correlation with GDP, while the debt and equity investments are backed by charities, associations and local government counterparties, giving them low correlation with other macro factors.
To illustrate the contradictory views of equity market strategists, Goldman Sachs’ David Kostin thinks the S&P 500 will reach 6,300 in 12 months’ time, taking its three-year return to 75%. Yet, he also thinks that the index will gain only 3% a year in nominal terms in the next decade.
At some point, equity investors could see steep losses. Mining the investment company universe for uncorrelated returns could help to ensure they stay committed to high-quality companies that end up, over the long term, winning out.
David Brenchley is an investment specialist at Kepler Partners. The views expressed above should not be taken as investment advice.