Summary

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  • A significant source of investment risk is derived from the volatility of asset class performance, complicating the choice of asset class to be invested in
  • It may be tempting to trade around market volatility. But it is difficult to consistently time the market correctly and may result in the sacrifice of key periods of strong asset performance
  • In the context of an investor’s risk profile, diversification may provide an opportunity to spread ‘cheap asset’ exposure across the available asset class universe - an efficient way to deploy our ‘risk budget’
  • Because different asset classes do not typically behave in a uniform manner, a diversified portfolio can benefit from losses in one asset class being offset by gains in another, resulting in a better risk-adjusted performance
  • A balanced portfolio may also help smooth cumulated losses over the investment horizon (‘drawdowns’), enabling investors to ‘stay in the market’ and reap the longer-term reward
  • Overall, combining a ‘risk budget’ diversification approach with strong valuation discipline, regular reviews, and if required adjustments, is the key to a successful long-term investment strategy

Investing – what’s the problem at hand?

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Investment typically involves taking a risk. The main problem is that asset class performance is volatile, complicating the choice of asset class to be invested in. For example, performance of different asset classes varies in terms of magnitude, direction and rank of return (Figure 1). In this instance, it may seem tempting to trade around the market volatility to try to capture gains during ‘up’ periods whilst avoiding losses during downturns.

However, this imposes an additional set of costs and, while theoretically attractive, it is a difficult strategy to implement in reality. How does one easily predict when a dip in the market is around the corner?

Figure 1: Annual asset class returns (2010-16)

Source: HSBC Global Asset Management, performance in USD

Staying out of the market may mean key periods of strong performance are sacrificed. For example, using the US S&P 500 index as a broad gauge of US equity market performance, investing USD100 at the end of 2005 for a period of 10 years would have a terminal value of USD202 (assuming dividend reinvestment). This is equivalent to an annualised return of 7.3 per cent. However, just by missing out on the top 10 days of performance reduces the terminal value to USD102 – a meagre USD2 profit, representing a 0.2 per cent annualised return.

The power of diversification

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Diversification within investment portfolios is an effective way of maximizing return within a specified degree of risk (a ‘risk budget’). Risk can be measured using an estimate of total portfolio volatility.

For example, a low target volatility portfolio would typically consist of a higher share of bonds (both government and corporate) versus equities. Implicit in this construct is the opportunity to apply ‘tilts’ to the weightings. If a positive short-term outlook on equities is held, the portfolio allocation can be increased above the longer-term strategic weight (an ‘overweight’ position). This is typically done on a valuation basis in order to increase the portfolio’s exposure to relatively ‘cheap assets’ which benefit from higher implied sustainable returns 1. Crucially, these tilts are applied within the constraints of the volatility tolerance level determined by a client’s risk profile.

While in principle diversification is straightforward, its benefits rely on the assumption that different asset classes do not behave in a uniform manner. Therefore, losses in one asset class may be offset by gains in another (whilst the same logic can also be applied within asset classes), smoothing the overall investment experience for the diversified investor.

We can use a simple example to illustrate this. First, we can consider the returns that you would receive with an entire allocation to either cash, equities or bonds in the period 1920-2015 (Figure 2). While equities saw a much higher annualised return, this comes at the cost of significant volatility, with 25 out of 96 years ending with negative returns. Meanwhile, although bonds have seen around a third of the volatility and fewer years with negative returns, the annualised returns were significantly lower. However, the construction of a simple portfolio composed of 50 per cent equities and 50 per cent bonds has a better risk-adjusted performance, represented by a higher ‘Sharpe ratio’. This is a simple measure of how well the return of an asset compensates the investor for the risk taken (also known as a ‘risk-adjusted’ return).

Figure 2: Portfolio returns under different asset class mixes (1920-2015)

Source: HSBC Global Asset Management, as of 28/12/016

Meanwhile, although the high return on equities versus safety asset classes is attractive over the long run, the bumpy journey results in periods of significant cumulated losses or ‘drawdowns’ (Figure 3). A balanced portfolio can also help reduce these losses over the investment horizon, enabling investors to ‘stay in the market’ and reap the longer-term reward.

Figure 3: Cumulated losses under different portfolio mixes

Source: HSBC Global Asset Management, as of 28/12/2016



1 Indeed, it can be shown that over a long-term horizon (eg 10-20 years) a relatively low starting valuation correlates with a positive inflation adjusted return. This applies across almost all of the investment universe.

Investment implications

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As we have shown, careful use of a diversified portfolio can boost an investor’s ‘risk-adjusted’ return and enable investors to ‘stay in the market’ for longer periods. For this reason, although we believe developed market government bonds are overvalued, they may still play an important role within multi-asset portfolios.

Meanwhile, for any given ‘risk budget’, diversified portfolios benefit from the opportunity to increase exposure to asset classes which may be judged to outperform (judged on a disciplined valuation basis). In this current environment, we judge these asset classes as global equities (in particular Europe and selective parts of EM) and local currency EM debt.

Overall, combining a ‘risk budget’ diversification approach with strong valuation discipline is the key to a successful long-term investment strategy.

Disclaimer

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For Professional Clients only and should not be distributed to or relied upon by Retail Clients.

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