Institutional investors that have diversified their assets away from developed market equities during the past five to ten years will have made the case for diversification as almost every other asset class outperformed See Table 1 under Notes to editors. these markets during this period, according to an article in Towers Watson’s Global Investment Matters publication. In the article, entitled Is diversification dead?, the firm asserts that the risk of an equity-focused strategy remains high, especially given ongoing economic uncertainty and recommends that investors should seek both existing and new market opportunities to build more diversified portfolios.
“Despite recent intermittent, short-lived peaks the equity party really ended as the new millennium began, so a heavy reliance on this asset class would not have been a good strategy since then, says Carl Hess, global head of investment at Towers Watson. While moving to a diversified portfolio is a higher governance approach than a simple bond/equity portfolio, we think the effort is worthwhile for almost all institutional asset owners.”
In the article, the firm suggests that a diverse portfolio of market opportunities, combined with better techniques to manage liability risks, can improve efficiency by 20 to 40 per cent compared to a simple bond/equity mix. So for a comparable level of risk, returns in excess of the risk free rate, can be expected to be 20 to 40 per cent higher.
“This type of portfolio See Table 2 under Notes to editors. can be made up of beta opportunities and does not necessarily need to rely on active management to any great extent, says Carl Hess. As such it can be implemented with considerably fewer managers than we would typically use in a fully active portfolio: so eight to 12 rather than 25 to 35 investment managers.”
The firm suggests three new specific diversification opportunities having considered the fundamentals: insurance-type strategies; the emerging market wealth theme; and alternative betas. Regarding insurance-type strategies it recommends reinsurance, accessed via catastrophe bonds, and other insurance-linked securities.
According to the firm many institutional investors still have a very small allocation to emerging markets, for example the emerging market weighting is only around ten per cent (excluding Taiwan & Korea) in a global equity index. It recommends investors increase allocations to emerging markets, via companies more directly exposed to emerging market growth, in areas such as infrastructure or domestic consumption, rather than on large global companies based in these countries. In addition, it believes that there is an alternative way of exploiting productivity growth by investing in a range of countries whose economic fundamentals look strong, via a basket of emerging market currencies. Furthermore, with over 70 per cent of the emerging market debt universe now denominated in local currency bonds, emerging markets are now much less exposed to a currency crisis making their debt a more attractive investment.
Towers Watson also believes the use of ‘alternative’ (or exotic) betas can have a strong diversifying effect on a fund’s portfolio if properly constructed. It suggests there are two main ways to access them: first by applying strategies that exploit asset classes not typically used by most investors, such as reinsurance and volatility strategies as well as emerging market currencies. And second through strategies that exploit systematic risk premia in conventional asset classes, which includes investing in value and small cap stocks, as well as carry and potentially momentum strategies across a range of markets, as well as merger arbitrage and convertible arbitrage.
D.C.