How to diversify your portfolio when the correlations are sky high

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How to diversify your portfolio when the correlations are sky high

Recent research suggests that the average correlation between different pairs of asset classes has risen beyond the level seen during the global financial crisis, which makes it harder to reduce the risk of your portfolio. 

The work by Fidelity International shows that the median correlation across nine types of global risk assets including equities, credit and commodities is now 0.8, compared to 0.6 during the global financial crisis. 

Correlation measures the extent to which the returns from a pair of assets move together and ranges from minus one, where they react in a perfectly inverse way to plus one where they are identical. The lower the correlation the less similar the performance and the greater the diversification benefit of holding the two assets alongside each other in a portfolio. 

Will bonds still act as a diversifier? 

The problem with all asset classes being highly correlated is that they will tend to move in a similar way, which is particularly dangerous when something bad happens, such as the advent of the coronavirus. Back in March pretty much everything sold off heavily at the same time including equities, corporate bonds and gold, with the one exception being government bonds.  

Bonds are the traditional diversifier for risk assets, but the potential returns look very weak with interest rates as low as they are and they could be vulnerable in certain scenarios. One such would be stagflation, where there is rising inflation with high unemployment and stagnant demand, which could force central banks to raise rates rapidly.

Even if they can’t raise rates because of the high debt levels the real returns from bonds after adjusting for inflation would still be negative. They would also come under pressure if growth improves and rates move up in a gradual and well-telegraphed manner. The one scenario where they should hold their value is if the low or negative yields that we have seen in recent years persist well into the future. 

Investment trusts to diversify your portfolio 

There are only a handful of investment trusts that can add meaningful diversification to the mainstream asset classes, with a good example being BH Global (LON:BHGG). The £374m hedge fund aims to generate consistent long-term capital growth by investing in the Brevan Howard Multi-Strategy Master Fund, which provides exposure to a range of different trading strategies. It recorded its largest ever monthly gain in March, when just about everything else sold-off strongly.

Another investment trust that held up remarkably well during the sell-off was the £445m Ruffer Investment Company (LON:RICA). The multi-asset fund aims to deliver a positive total annual return, after all expenses, of at least twice the Bank of England bank rate, but it has done much better than this and has beaten the FTSE All-Share over the period since its launch in 2004. It has done this by holding a mixture of equities, index-linked bonds and gold, alongside illiquid strategies and options to protect against a market crash. 

Another area that can add diversification is infrastructure, with one option being the £2.8bn HICL (LON:HICL), which invests in lower risk infrastructure assets mainly located in the UK. Only about a fifth of the portfolio consists of demand-based assets, with the rest being largely unaffected by the pandemic. Its shares sold-off in March alongside the broader market, but they have since recovered and offer a sustainable 4.7% yield, although they are currently trading on a hefty 18% premium to the estimated NAV. 

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