The investments that are better than bonds for diversification

If investors have learnt nothing else from the volatile markets of the past year, where even bonds and equities were positive correlated at one stage, it’s that true diversification is crucial. Traditional views of diversification are out, and alternatives are filtering into public consciousness as a means of creating true diversification.

To be a true diversifier though, there are a few key elements an asset needs to have according to Brendan Paul, portfolio manager and co-head multi asset for Atrium Investment Management.

“One is an absolute return focus, so that comes back to generating positive absolute returns over an investment cycle,” says Paul.

It also needs to have low or no correlation to any other risks in your portfolio.

In the current market, there are a few assets that meet the bill for Paul and he shares three in this edition of Expert Insights. He also discusses the elements that classify an asset as a diversifier and the ranges he uses for diversifiers in his portfolios.

Edited transcript:

What qualities does an asset need to have for Atrium to consider it a diversifier?

There's a couple of key elements.

One is an absolute return focus, so that comes back to generating positive absolute returns over an investment cycle with about three or five years that you're looking out. And that's regardless of what's happening in equity markets or what's happening in bond markets. 

In relation to that is the correlation element. So that means how do the returns move in relation to one another? Are the investments really just underlying it a lot like equities? If equities are going to fall at the same time, this investment will fall. It's not offering you any diversification benefit.

You want what we call low or no correlation between the diversifying investment strategies and the risks that we take elsewhere in the portfolio. 

We are investors in equities, and we are investors in bonds, but we want that bucket to be the ballast. 

We want it to be the stabiliser when times are rocky, and it really helps us achieve our risk targeted philosophy, which is hitting a risk limit and not a return objective.

We have risk limits for our portfolios, and they're measured by the volatility of returns in those funds. We want the diversification benefits of our liquid alternative strategies to keep that volatility under control when markets are getting a little bit chaotic and a little bit volatile like they did in the pandemic.

What sort of range would you typically allocate to diversifiers?

Historically, we've been between about 10% and 35% in diversifiers in our multi-asset portfolios. At the moment, we're right up at the top end of that range in our portfolios.

We are maximising the use of diversifiers because we think that they're going to play a critical role in that future where the 60:40 portfolio is not going to do as well as it has historically. You really want that bucket of diversification, the ballast in the portfolio that's going to give you a positive absolute return, and that return's going to be unrelated to equities and bonds. It's going to be a key driver for portfolio outcomes for us over the next couple of years. We are working really hard on researching that part of the portfolio.

It's also well proven that, in periods of higher macroeconomic volatility, those alternative strategies tend to do better. Given our sort of view is that we are in that environment, we're allocating at the higher end of that range at the moment.

Can you discuss two asset examples of diversifiers you use?

One recent example that we've invested in that we found interesting is catastrophe bonds.

Catastrophe bonds are much like a corporate bond. They're issued by insurance companies to help when the insurance company needs to pay out for a natural disaster, say a hurricane or an earthquake or a wildfire. They pay a coupon, an income-type instrument just like a corporate bond would, but the risk of loss is attached to the risk of the natural disaster.

It doesn’t have corporate risk from the insurance company or from the equity market or anything like that. It's the risk of the natural disaster occurring.

We’ve been following these strategies for a number of years. What’s particularly interesting at the moment, before the pandemic, the coupon on these bonds was around 3- 4%, and the expected loss from natural disaster in any given year was about 2.5%. The ratio of that return per unit of risk wasn't particularly attractive in our opinion.

Now, due to a number of market events, including a hurricane a couple of years ago, but also less demand for these bonds in the market as interest rates have risen, the coupon available now is closer to 13%. But the interesting thing is that expected loss from the natural disaster is unchanged. It’s still 2.5%. That's not withstanding climate change. We recognise the risk of these natural disasters has increased in recent years, and that's all modelled out, but the return per unit of risk is far more attractive than it was a few years ago.

That is interesting to us as someone looking for a diversifying strategy because it's a really good absolute return, and the risk of loss is very different to the risk of loss in other parts of the portfolio. It fits nicely into that diversification bucket.

The other example I would give is a commodity-based strategy. 

Gold is often cited as a good diversifier in multi-asset portfolios, and we do have a small allocation to gold at the moment. It has interesting qualities as a protection against longer term inflation and also against the basement of the US currency, for example, in its precious metal status. But we also have a strategy which is absolute return in commodities. That means it can go long and short. It goes long and short across precious metals, energy commodities, and also base metals like copper and nickel and things like that.

There's a number of events that are taking place:

• around the role that China and the risk of China has in the global economy. China is a heavy user of resources and commodities.
• the role that the energy transition is going to have for the demand for energy resources and those commodities, and
• the infrastructure spend that's projected in the US over coming years.

All these things are coming at the same time will have an impact on commodity prices, but also the volatility of commodities. 

We’re attracted to this strategy, which is designed to be market neutral and commodities that take advantage of price movements across all those base metals and precious metals and energies, and that we think is going to be diversifying. We think it's going to have a positive absolute return over that three-to-five-year time horizon. We think that the risks in that portfolio are very different to other risks that we have in other parts of the portfolio.

Do you have any final tips on opportunities in diversifiers to consider?

We also have another strategy that we allocate to, which is commonly known as trend following. It's really a momentum-based strategy that looks at the price movements across a whole range of markets, all the way from equity markets, global bond markets, currency markets, commodity markets, soft commodities, sugar.

These strategies trade the price of cocoa beans, orange juice, futures, some really esoteric markets. What they're really looking for is just a trend in the price, and they're looking to capture that momentum, and we do allocate to those in our strategy. We think they have some really unique benefits for a multi-asset portfolio. A well-constructed trend strategy can act as a sort of tactical asset allocation model. If equities are doing very well and trending, then they will add to your equity exposure for you.

But a better example in recent times when bond markets were very weak in 2022, these managers were short those government bond markets and were able to profit and provided us with some really great diversification benefits in that exact environment where bonds and equities are falling at the same time. We think that just a good old fashioned trend follower or momentum-based strategy does have a real role to play in these multi-asset portfolios.

Learn more

Brendan and the team at Atrium help investors maximise the benefits of diversification by bringing together a blend of best-in-class investment managers and strategies, carefully selected, and incorporated into a range of professionally managed multi-asset diversified solutions. Visit their website to learn more

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