What does real diversification look like?
Diversification is one of the most important concepts in financial markets. Its purpose is to protect investors when markets are volatile or on a downward trajectory.
But it’s easy to think your portfolio is diversified when it’s not. This is especially the case given current market conditions. Here, we explore what true diversification is and how SMSF investors can ensure this concept helps shape the construction of their portfolios.
First, it’s important to define diversification. The most common analogy used is not putting all your investment eggs in one basket, to ensure the portfolio derives its returns from a variety of sources.
There are many ways of being diversified and new thinking has emerged around sources of diversification. For instance, it was once thought certain asset classes such as shares and bonds were uncorrelated. The assumption here is that when one asset class, for instance, shares, falls, another one, for instance bonds, will rise.
But during periods of market dislocation, often the values of different asset classes fall in tandem. Therefore, it’s important to identify other sources of diversification beyond asset classes.
For instance, it’s important to look for sources of diversification within the same asset class. An example is equities. Within this asset class, it’s possible to be diversified across industry sector and for both growth and value businesses.
But overall, a truly diversified portfolio would ensure no more than 15% to 20% of the fund’s assets are held in a single asset class.
Achieving diversification in defensive assets
A portfolio’s defensive exposure is one area where it is tricky to be truly diversified at the moment. Many defensive assets such as bonds have become expensive. This means alternate strategies are required to build a portfolio of assets in this class that are not too expensive, but that also offer the defensive properties that will help protect the fund when markets trend down.
One option is to consider how much of the defensive portion of the portfolio should be held in cash. It’s important to remember that the return cash produces has the potential to diminish overall portfolio returns. But having some cash holdings also allows investors to take advantage of well-priced investment opportunities, including defensive ones, when the opportunity arises.
There is also potential for SMSF investors to use exchange-traded funds (ETFs) to achieve their exposure to defensive assets. There are a range of ETF options to consider. An idea to achieve diversification in this part of the portfolio is to buy both nominal and inflation-linked bond ETFs.
It’s important to explore alternative strategies given how tough it is to identify cost-effective defensive assets to provide proper diversification in a portfolio.
One possibility is to use options to enhance the defensive part of a portfolio. Options can act as a source of stabilisation in the portfolio, but it is important to actively manage them. For instance, an investor who has exposure to overseas assets might use currency options to hedge away currency risk.
But SMSF investors must follow certain procedures before they are able to use options, which are derivative instruments, in their fund.
First, the fund’s investment strategy must allow for it to employ options as a strategy. This means the strategy must clearly include a statement in writing that the fund can buy and sell derivative instruments.
The fund also needs to develop a statement about how derivatives can be used in the portfolio known as a derivative risk statement. The statement should cover how and when derivatives such as options can be used, acknowledging the risk to which the fund is exposed by using options.
It’s important to remember that options are high-risk financial instruments that must be fully understood before they are used because they have the potential to both enhance and detract from portfolio returns. They should also only be considered as a short-term solution to address present issues in the market that make it difficult to be truly diversified.
Over time, the best way to be truly diversified and generate good returns is to look for well-priced assets with the potential for outperformance. This should be an ongoing focus for SMSF investors.
About the author
Nader Naeimi, Head of Dynamic Markets at AMP Capital. He is also the portfolio manager of the Dynamic Markets Fund.
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