Few people predicted how 2016 was going to turn out. Given Brexit and a Trump presidency and the bottoming of the interest-rate cycle, further surprises for financial markets could come thick and fast in 2017. What’s the answer for investors? Diversification, suggests Mike Brooks, Head of Diversified Multi-Asset Strategies.
What surprises should investors be braced for in 2017 and beyond?
It’s important to remember just what a year of surprises 2016 was – not only in terms of the result of the US election and the UK’s European Union (EU) referendum, but how markets and policymakers acted. We saw interest rates turn negative, resulting in an estimated $15 trillion of sovereign debt trading at real negative global yields interest rates. The US Federal Reserve confounded expectations and only raised interest rates once. But at the same time, we saw both equity and credit markets deliver positive results across the globe.
However, 2017 is the year that speculation turns to action. Donald Trump is likely to establish major policy proposals in his first 100 days and the UK government will start giving concrete detail on its plans to leave the EU. Mix in China’s economic slowdown and elections in France, Germany and the Netherlands and you see there is potential for major market shocks and surprises. Many of these factors have implications for global trade, so we could see sharp gyrations in performance by market and by industry sector.
So how can diversification help?
Despite their continued strong performance in 2016, we believe this is no time to have all your assets tied up in conventional bonds and equities. More importantly, this is no time to rely on market-timing to get you into the right asset class at the right time. Our view is that taking a long-term view on a wide variety of different asset classes is the key to achieving return and reducing downside risk. There are asset classes now that weren’t available 10 or even five years ago – including insurance-linked securities, peer-to-peer lending, renewable and social infrastructure – which can help reduce reliance on equity markets for growth and reduce risk in a portfolio by lowering volatility and downside risk.
Are we seeing greater levels of diversification among investors?
Well, a good example is the Yale Endowment Fund, a US$25.4 billion fund which is the largest source of funding for Yale University. It has reduced its exposure to domestic US equities from 60% 30 years ago to around 5% today. Many of the world's other most sophisticated institutional investors have also diversified their portfolios making greater allocations to asset classes such as infrastructure, direct lending and emerging market bonds.
The good news is that almost anyone can achieve a similar ‘institutional’ level of diversification through a diversified growth fund (DGF).
What’s the benefit of a diversified growth fund over a DIY approach to portfolio diversification?
First, a DGF can provide access to an array of asset classes, typically a dozen or more, that would be hard and costly to replicate fund by fund. Second, the portfolio should be constructed to ensure that the blend of asset classes is optimal in terms of return and risk. So some asset classes will be chosen for their strong growth potential, others for their steady yield, and others for a return that’s less affected by stock market sentiment or interest rates. By blending multiple return drivers that are largely independent of each other, a diversified growth fund is far less vulnerable to external shocks than, say a pure equity fund.
Are the benefits of diversification coming through in performance?
In our experience, yes. The Aberdeen Diversified Growth Fund was launched in November 2011 and invests in a broad blend of real assets, special opportunities, and higher yielding bonds and equities. It has achieved its rolling five-year internal target return of Libor + 4.5%*. But volatility has consistently been half that of the MSCI World Index, ranging from 3-6% rather than 6-13%. Aberdeen Diversified Growth Fund performance:
How should investors view the role of a DGF in the current climate?
A DGF should function as the long-term core of a portfolio, giving you the stable growth potential you need to weather external events, while still keeping you on course to meet your investment goals. Having that solid core in place should make it easier to handle whatever unpredictability the next few years will present.
 Source: Aberdeen Asset Managers, BPSS, Thomson Reuters Datastream, SMEP, 31 October 2016
 Source: World Gold Council – ‘Gold in a world of negative interest rates’, March 2016
 Source: Yale Investments Office, June 2016