Why diversification is back – and how to do it properly

Portfolio diversification, within an asset class and between them, is a core building block of successful wealth generation.

The theory is owning a wide spread of investment means that when one part of your portfolio is falling, another should be rising, so overall you are able to weather different market conditions.

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This way, investors can gain from the general trend of rising stock markets but with reduced volatility, and also benefit from the protection and income that bonds have historically offered.

Vanguard, the index fund group, says: “There's always a risk of losing money when you invest. The good news is that you can avoid one type of risk—the risk of investing everything in a company that goes under—by buying hundreds or thousands of securities at a time.

“This is what's called ‘diversification.’ It works best when you buy into multiple industries and include companies of all different sizes because this variety helps even out the ups and downs.”

But two things are making diversifying more complicated: bonds crashed in value last year, therefore upending the argument that they go up when stocks fall; and indices are becoming extremely concentrated in just a handful of US technology firms, prompting calls that tracking US or global shares doesn’t offer much diversification.  

So what does sensible diversification look like in 2023? We take a look.

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Is the 60/40 back?

The reputation of the classic 60/40 split of shares to bonds has taken a beating due to fixed income markets falling in response to rising interest rates.

Since the start of 2021, the Bloomberg Sterling Aggregate bond index has fallen 25%, while the Bloomberg Global Aggregate bond index has fallen 10%.

This meant that mixed asset funds, such as Vanguard’s LifeStrategy range, with the most invested in bonds were the funds that fell the most.

Since the start of 2022, LifeStrategy 20% Equity has fallen 15%, while LifeStrategy 100% Equity has risen 1%.

But now, this “reset” in bond prices following many years of rising prices means that yields are now higher, providing a better entry point for new investors.

Yields on corporate bonds, paying investors in sterling, are about 6.5%. While yields on UK government bonds, known as gilts, range between 4% and 5%. Interest rates are also close to peaking, according to economists, and inflation is falling rapidly, meaning that central banks should have room to cut rates to stimulate economies.

Bond prices tend to move in the reverse direction to interest rates, as higher rates make newly issued bonds more attractive, leading to existing bonds being sold so that yields come into line with market rates. Higher interest rates are also usually indicative of higher inflation, which erodes the value of the fixed income that bonds offer.

Vanguard says: “For the traditional 60/40 portfolio, 2022 was a punishing year. But the old standby’s long-term record has been stellar and, with current valuations, expected returns for the next decade have improved.”

The fund manager calculates that the expected 10-year outlook for 60/40 portfolio is 6.09% a year, as of the start of 2023, compared with 3.83% at the start of 2022.

It adds: “While 2022 may have been painful for investors, the result was that valuations for asset classes are now lower, and most are fairly valued. The notable exception is US stocks, which are more reasonably priced now but still above what we consider to be the fair-value range.”

However, the group says that a decade of rising inflation could upend the 60/40 model.

"Barring that scenario, the 60/40 is still that reliable family minivan that will help get you to your destination," Vanguard said.

BlackRock, which manages the multi-asset MyMap portfolios, says that while the negative correlation between stocks and bonds has returned, there could be more difficulties ahead.

MyMap portfolio manager Christopher Ellis Thomas, said: “Inflation is likely to fall from its current elevated levels but is forecast to stay above central banks’ 2% limit for some time. In the longer term, changes in the macro environment look set to continue the inflationary trend.

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“Chief among those is geopolitical risk, leading to geopolitical fragmentation and the rewiring of supply chains. Shrinking workforces as a result of ageing populations will constrain production, prompting higher prices.”

Against this backdrop, it opts for a “dynamic” approach to diversification, so rather than sticking with rigid stock and bond allocations, it adapts its portfolio every three months.

It has recently been buying more Japanese and Asia Pacific equities, while diversifying within fixed income by holding more investment-grade corporate bonds. It also invested in satellite assets such as gold and commodities.

Lindsey Knight, a director at Baillie Gifford, the Edinburgh-based fund group, says that while diversification may not have been rewarded recently, it is still a very important part of investing as a portfolio’s risk/return trade-off can be enhanced significantly by investing across a range of asset classes.

She explains: “This is because the volatility of a diversified portfolio is lower than the weighted average of the volatilities of each asset class held. Plus, the expected median return is greater than the weighted average of expected median returns on the individual asset classes held.”

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In short, the greater the number of assets held, the greater the likelihood of extreme positive outcomes.

Baillie Gifford says it is finding opportunities in more niche parts of the investment world.

“Many of the asset classes we think look the best value, where we see the most significant gap between their long-run average returns and prospective future returns, might be classified as ‘alternative’ or ‘diversifiers’. These include, for example, emerging market hard (dollar-denominated) currency debt, mezzanine structured finance and property,” Knight said.

Baillie Gifford expects emerging market bonds issued in dollars to return 6% a year over the cash, while high yield bonds and property could deliver about 5% above the cash rate.

How to avoid too much US tech

Investors opting for a passive fund that tracks the MSCI World index, such as Fidelity Index World or iShares Core MSCI World Ucits ETF may think they own a diversified portfolio of more than 1,500 companies, but looking under the bonnet of the portfolio tells a different story.

As of July 2023, the price-to-earnings (PE) ratio of the MSCI World index, which is a measure of how expensive shares are relative to profits, was 20.75 times, which is well ahead of the 12 times that the UK market trades at. Moreover, the global index is 70% invested in American companies, with Apple and Microsoft the biggest positions at 5.2% and 4.1% respectively.

This means that the leading global index moves broadly in lockstep with American shares, so  sticking with a global tracker fund does not necessary indicate a diversified portfolio.

Dan Brocklebank, of Orbis Investment Management, says that investors solely relying on this approach are taking more risk than they realise, as they are paying a lot for shares and profit margins are likely to revert back to normal levels. He adds that while it may seem like today’s top stocks will keep their crown in a decade's time, history shows inflated valuations come before a change in market leadership.

He says: “There is always the argument that the companies will stay the same, but competition will come in and disrupt the top firms. You don’t want to be saying that this time is different. You need to put the odds in your favour and owning market capped weighted US and global trackers funds does not put the odds in your favour.”

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To build a diversified portfolio, he says that a good starting point would be the inclusion of some tracker funds that are equal weighted, meaning they own the same amount of every stock.

Examples include the Invesco S&P 500 Equal Weight Ucits ETF and Invesco Nasdaq-100 Equal Weight ETF.

For investors looking at active funds, he says that many of the largest strategies are beginning to look like each other due to the long period of growth’s outperformance, so hunting for fund groups that think differently to peers is essential.

Brocklebank adds: “Be willing to look past big funds. Cheap stocks tend to outperform over time, as human nature means we undervalue companies.”

Brocklebank also points out that increasing investments in Japanese and UK shares will act as a counterbalance to tech-heavy US and global market trackers. These markets are far cheaper than US shares. The Orbis Global Equity fund has 13% invested in Japan and 11% invested in the UK, compared with 6% and 4% for its benchmark, the MSCI World index.

Japanese shares, which have had a strong start to the year, can keep performing well, Brocklebank argues.

“Japan in 1990s was a bit like the US today, but share prices have been punished so much since then that companies have become very conservative. The index trades on a book value of less than one, meaning that the assets of companies are worth more than the value of the shares.

“The regulator is making companies respond to this, and the reaction could be that companies take their cash piles and buy back shares or pay dividends. This would be good news for share prices.”