Dialling up portfolio diversification when uncertainty prevails

The term uncertainty is a recurrent theme this quarter. As systematic portfolio managers, this regime of trendless market evolution presents an interesting test for our investment process, questioning the level of diversification our investment solutions can provide. We aim to combine assets and strategies that do not correlate perfectly. In doing so, we seek to ensure that any part of our portfolio suffering a setback will be at least partially offset by a better performance elsewhere.

We can gauge the effectiveness of these protective measures through the diversification ratio, which measures the level of diversification within a specific allocation and market context. Here, we consider whether the rise in uncertainty is challenging diversification by examining the historical behaviour of our solutions’ diversification ratio and the changes since the new US administration took office.

Read also: Addressing uncertainty through risk-based portfolio management

Diversification at work

The concept of diversification is a fundamental aspect of investment, and most professionals have learned to appreciate its benefits over time. When two assets or strategies have an imperfect correlation, their combined risk is lower than the sum of their individual risks. Simply put, combining assets results in portfolios that exhibit lower volatility than their components.

From this definition, it becomes clear how one can measure diversification. This is typically done through the ‘diversification ratio’, which compares the sum of the risk contributions from the portfolio's individual constituents with its overall volatility. The higher the ratio, the more significant the diversification provided by the portfolio. This ratio can be calculated for any portfolio, such as a 50/50 portfolio or our All Roads solutions, and it varies due to two main factors: the changing risk and correlations of the constituents, and the portfolio allocation decisions. Figure 1 presents the time series evolution of this ratio since 2015 for the two aforementioned solutions, which explains one of the key success factors of our solutions over time.

FIG 1. Diversification ratio through time for All Roads and a 50/50 allocation¹

The key points are:

• Firstly, the 50/50 portfolio shows a diversification ratio that typically oscillates between 1 and 2, while All Roads' varies from 1.5 to almost 8. This reflects the scale of our opportunity set (the assets and strategies we use as constituents) as well as our dynamic portfolio management methods
• Secondly, the primary driver of the diversification ratio for the 50/50 portfolio is the equity-bond correlation. When this correlation spiked in 2022, the portfolio's diversification suffered. We have long maintained that ‘not putting all your eggs in one basket’ is crucial in investing, and that diversifying your diversification sources is equally vital. ‘Diversify the diversifiers’ is a mantra that helps maintain portfolio diversification even during challenging times. During key periods such as summer 2015, Q2 2018, 2020 and 2022, the diversification of our solutions spikes, unlike that of the 50/50 portfolio.

Despite the recent decline in the diversification ratio of our solutions (it is currently at around 1.75), they continue to show greater diversification than the 50/50 portfolio. The extensive set of risk premia in which we invest remains a source of global diversification.

Where is my diversifier?

Understanding the level of portfolio diversification is crucial, but identifying its sources is equally important. In times of uncertainty like today, it's insightful to analyse the individual sources of diversification within our solutions and determine if these contributors are changing. This analysis can be conducted by computing the marginal contribution to the diversification factor. Essentially, this involves comparing the diversification ratio with and without each of our investments. The difference in the diversification ratio between these two scenarios serves as a measure of this marginal diversification contribution.

Figure 2 illustrates this decomposition over the long term, for 2024 and since the beginning of the year. This latest data point should help us identify which asset class currently provides the best source of diversification. The main takeaways are:

• Before Donald Trump's return to the White House, the sources and cumulative level of marginal diversification contributions remained largely unchanged, dominated by bond investments, followed by emerging market (EM) equities, with commodities and credit spreads trailing
• Since the beginning of the year, the cumulative diversification contributions have halved, with most of this impact affecting bonds. Bonds are the component experiencing the largest decrease in diversification potential. Interestingly, EM equities, which typically contributed a fifth of the diversification provided by bonds over the longer term, are now contributing half as much as bonds.

FIG 2. Cumulated marginal contributions to the diversification ratio per asset class²

The current uncertainty is reflected in the fluctuation of our solutions’ diversification potential, which is near its low. This highlights that bonds, despite continuing to be the best provider of diversification, are currently less effective a tool than they have been in the past. In these turbulent times, we continuously monitor such metrics, recognising that diversification – which essentially means not relying solely on the stability of uptrends – is one answer to uncertainty.

Simply put, diversification has declined in Q1, with bonds playing a lesser role. Risk-based investing, nonetheless, continues to show better diversification than its market cap counterparts.

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Simply put quarterly edition: Investing in a period of uncertainty.

 

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