The concept of diversification was famously described as the ‘only free lunch in finance’ by the father of portfolio theory, Harry Markowitz. Creating a portfolio which successfully combines uncorrelated assets to smooth returns and minimise losses is central to successful investment. It is a widely accepted way to create a portfolio that will perform over the long-term and in diverse market conditions.

However, while Australian investors may understand the ‘why’ – the benefits of diversification – there has never been a more important time to re-think how to diversify.

Traditional thinking about asset class de-correlation is changing.

Alternatives, alternative strategies and liquid alternatives have proven themselves to be effective long-term diversifiers, able to produce absolute returns in a lot of market conditions. These strategies are subject to increased scrutiny and interest, and have been widely embraced by sophisticated institutional investors. Australia’s sovereign wealth fund, the Future Fund, has steadily increased its allocation to alternatives over time, from 0.6% of the fund in September 2008 to 15% in September 2018, [1] and described its alternative beta strategy as having served the fund well.[2]

So why is it so important to consider alternatives now? Firstly, because market volatility is very likely here to stay. In fact, some US equity market analysts[3] are predicting a new era of elevated price swings, and warning investors to brace for enduring stock volatility as the tide of liquidity (injected by central banks over recent years) recedes.

The second and more important reason is that correlations between asset classes are changing, a trend that has recently become more pronounced. This means that traditional thinking about how to achieve portfolio diversification must also change. The addition of fixed interest to a portfolio to diversify away from equity risk has long been the go-to strategy for many investors, but the global financial crisis subverted the expected de-correlation of equities and bonds. Instead, these and other asset classes began to move in lockstep, exacerbating portfolio losses at exactly the time investors sought to minimise them.

‘Alternative strategies’, however, are slightly different. These strategies may invest in traditional assets as part of an underlying portfolio, but they do it in a different way. For many years, alternative strategies were the preserve of hedge funds, and available only to a small number of institutional or very high-net-worth sophisticated investors. These funds used multiple strategies, both long and short, more leverage than traditional funds, and invested in many asset classes, with the result that funds often had little or no correlation to traditional benchmarks (although they could still present significant risk).

Why is it so important to consider alternatives now? Because market volatility is very likely here to stay.

For most investors, when thinking about alternatives, the assets classes of property, infrastructure and private equity spring to mind. These are ‘alternative’ to equities and bonds, and considered to have low correlation with them.

‘Alternative strategies’, however, are slightly different. These strategies may invest in traditional assets as part of an underlying portfolio, but they do it in a different way. For many years, alternative strategies were the preserve of hedge funds, and available only to a small number of institutional or very high-net-worth sophisticated investors. These funds used multiple strategies, both long and short, more leverage than traditional funds, and invested in many asset classes, with the result that funds often had little or no correlation to traditional benchmarks (although they could still present significant risk).

For most investors, when thinking about alternatives, the assets classes of property, infrastructure and private equity spring to mind. These are ‘alternative’ to equities and bonds, and considered to have low correlation with them.

Liquid alternatives are quant-based and systematic, so recognise the benefits of using data and technology and applying a scientific investment approach to generating absolute returns with low correlation to traditional assets. These strategies, like long-term trend following, perform as a result of their ability to capture returns on the basis of a few core, persistent and well-documented strategies.

These strategies, now offered by a number of independent platforms, are liquid, scalable, transparent and low cost – and offer investors a diversified portfolio with a potentially smoother return profile. All of which makes the ‘how’ of diversification as easy as the ‘why’.

Disclaimer:
Capital Fund Management LLP (CFM LLP) is registered as a Foreign Services Provider (“FFSP”) with ASIC under ARBN 624 703 886, operating under the same Class Order CO 03/1099 applicable to UK FFSP. CFM is regulated by the UK Financial Conduct Authority under the laws of England and Wales. Pursuant to ASIC Corporations (Repeal and Transitional) Instrument 2016/396, CFM LLP is exempt from the requirement to hold an Australian financial services license under the Corporations Act. The laws of England and Wales differ from Australian laws.

[1] Future Fund Asset Allocation at 30 September 2008 and at 30 September 2018
[2]The role of listed equities in the Future Fund portfolio
[3]Bloomberg: Bank of America has seen the future: A U.S. stock roller coaster

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