Does diversification need a rethink?

In 2022, traditional investment diversification strategies conspicuously failed to work as they were expected to. Supposedly safe government bonds provided no protection against falling stock markets, calling into question the historic relationship between bonds and equities. Do investors need to rethink diversification?

The traditional approach to diversification has been to hold developed market government bonds alongside more volatile stock market investments. The basis for this is that developed country sovereign bonds tend to benefit in a climate of weaker economic growth and deflationary pressure, while stock markets generally outperform in an environment of expanding economic activity, when there is greater demand for goods and services and companies earn larger profits.

The reason this theory didn’t apply in 2022 was that both bond and equity markets proved sensitive to surprise in inflation expectations. As inflation took hold and interest rates rose in response, it was bad for both asset classes, which experienced double-digit index declines.

Benign inflationary conditions

Viewed over the longer term, this is not particularly unusual. Research by Bank of England economist Matt Roberts-Sklar in 2016 found that for significant periods over the previous 250 years, equities and bonds had been positively correlated. It is only during periods of benign inflationary conditions that the diversification effect comes into play.

That’s what has characterised much of the past three decades. The rise of China and its huge manufacturing industry, ageing populations and the implementation of credible inflation targeting by independent central banks has helped lower inflationary expectations. The problem is that investors have started to assume that a mix of bonds and equities will always offer diversification.

It is worth noting that while equity and bond diversification didn’t function in 2022, other types of diversification were indeed effective. Investors who held a spread of value and growth equities, for example, would have seen the fall in growth sectors such as technology compensated by exposure to value areas such as energy or materials. At the same time, some emerging markets showed little or no correlation to US and European markets; the Indian stock market, for example, enjoyed double-digit gains during the year.

The same was true within bond markets. The higher-yield end of the bond market is more sensitive to credit risk than interest rates. Default rates remained relatively low and lower-rated bonds performed better than their investment-grade peers. Emerging market debt also protected investors’ capital over the year.

An important truth is that diversification and correlation between different asset classes is fluid rather than static – sometimes bonds and equities will be correlated and sometimes they won’t, depending on market conditions.

Fluidity of diversification

So instead of saying that diversification in general failed to work, we should specify bond/equity diversification. This speaks to an important truth about diversification and the correlation between different assets – it is fluid rather than static. Sometimes bonds and equities will be correlated and sometimes they won’t, depending on the market conditions. Any diversification strategy needs to take this into account.

With that in mind, will bonds and equities be correlated in the immediate future? Certainly, bond markets looked very different in early 2023 compared to 12 months earlier, with the yield on a 10-year US Treasury bill rising from 1.8% to 3.9%. Following the Japanese central bank’s decision to relax its yield targets in December 2022, there have no longer been any government bonds with a negative yield – compared with $18 trillion worth in 2020.

For the first time in a decade, investors can obtain a significant income from sovereign bonds, and bonds now seem well placed once again to fulfil their role as a diversifier within portfolios. However, this does not mean investors can neglect effective diversification across portfolios. The environment can change quickly and circumstances exist in which asset class correlations could again increase – which calls for diversification both across asset classes and within them.

This may involve holding a range of different types of equity – dependable defensive companies, alongside punchier higher-growth stocks. In an era of deglobalisation and increased protectionism, investors may obtain greater diversification benefit from investing across different regions. Allocating to assets across both developed and emerging markets can offer a broader range of opportunities. In fixed income, blending high-yield or emerging market debt with higher-quality investment-grade and government bonds can help balance a portfolio and equip it for different types of economic environment.

The role of alternatives

Alternatives also have a role in ensuring a portfolio is adequately diversified. Some asset classes, such as infrastructure and commercial property, are sensitive to rising interest rates, but provide some protection against inflation. Some hedge fund strategies and absolute return funds are designed to exhibit little correlation to bond and equity markets. The best fund manager may be able to eke out returns in all market conditions – although these strategies are not fool proof.

The role of cash as a diversifier should not be neglected. While holding significant weightings in cash at a time of high inflation might be perilous, in 2022 it did a far better job of protecting overall portfolio value than many other asset classes and has provided investors with the ability to reinvest in markets flexibly.

Gold may also have a place in the investor’s portfolio. It has a relationship with interest rates – paying no income, it tends to do badly when rates are high because the opportunity cost of holding gold is greater. The gold price was flat during 2022, although it experienced plenty of volatility throughout the year. It has proved very difficult to judge when gold might perform well, so many asset allocations incorporate a constant small holding.

No diversification strategy is effective in all market conditions.

The significant correlation between bonds and equities in recent times does not call for a fundamental rethink of the way investors consider diversification. However, it should be a reminder that no diversification strategy is effective in all market conditions, and that investors should be rigorous in their approach. No-one has a crystal ball, and diversification is often the only way to protect a portfolio against unpredictable markets.