When we consider modern portfolio management, we think of investors having hundreds if not thousands of bonds and equites in their portfolios to limit exposure to a company, sector or country, ensuring you are fully diversified, right?
Nice theory but in practice we are doing the opposite. I argue that we are building highly concentrated portfolios, increasingly reliant on the risk of fewer companies and economies.
Portfolios are built on the premise that bonds are low risk and equities are high; change the mix and hey presto you get risk adjusted portfolios. But what happens if that core assumption of portfolio theory breaks down? Let’s take a closer look at some real world data.
Bonds are not low risk
Thanks to supportive Central Banks interest rates are at a record low. Due to falling interest rates since the 1980’s, low risk government bonds no longer pay a sufficient yield to justify including them in portfolios. (see table below). Anyone interested in -0.32% return on 10 year German bonds [effectively paying the German government to mind your money] or perhaps the generous 0.06% on French bonds? These low rates have made government bonds almost un-investible for many portfolio managers.
Fig 1 10 year European Bond Yields
Portfolio managers have quite sensibly responded by looking to increase investors returns by what they call “going out the risk curve” or in short increasing the number of more risky corporate bonds (company debt) in their portfolio to increase the yield (income). Companies have in turn answered the call for their debt with a huge increase in issuance illustrated below:
Fig 2: Bloomberg Barclays Global Aggregate Corporate Total Return Index
For more on this topic read the excellent article by Mohneet Dhir of Vanguard warning investment managers need to keep to their mandates, despite the low interest rates, or they will add risks that will come back to hurt investors.
This leaves investors carrying significantly more risk in the “low risk” bond component of their portfolio than traditionally would have been the case. It is also likely that those same companies in your bond portfolio will also be in the equity funds of your portfolio. So now you are holding both the equity and the debt of the same companies. This does not feel particularly diversified and is an indication of the increasingly concentrated risk that investors are taking in their portfolios whether knowingly or not.
Well what about my thousands of equities?
If risk management is of concern, then investing in five thousand different companies rather than 5 will lower your risk. This still remains relevant today but one of the drawbacks of a globalised financial world is the high correlation between global stock markets (how much they move together in tandem). Research has found that during times of crisis, global stocks behave in a highly correlated manner, they go up and down together at the same time.
The US equity market accounts for almost 55% of global equity markets by capitalisation and 21% of the S&P 500 (representing the largest 500 companies in the US) is made up of just 5 stocks (FAANG). The S&P 500 is commonly used as a proxy to obtain exposure to the US market. Assuming you invest €1 in a global equity index fund, 55c is going to the US market and 12c of your euro is going into 5 stocks. Still feeling you are in a globally diversified portfolio?
Multi-asset class investing the solution?
Multi-asset class investing is when you wrap up all your investments in one fund, a common approach in pension schemes giving investors a broader exposure of investments. But the below asset allocation from a leading investment manager illustrates this is not much of an improvement with a heavy allocation to equities and corporate bonds. This is standard across the market and it concerns me.
Fig 3 Asset allocation of large Irish pension fund
Source: Example of domestic pension fund, figures have been changed and does not represent any individual fund. ESMA 4
What is the alternative?
A wider number of asset classes needs to be considered rather than just bonds and equities in investor portfolios. Increased allocations to commodities, gold, private equity, land and direct property will provide greater diversification and better risk adjusted returns. The below asset allocation from the Standard Endowment fund in the US illustrates how large private institutions and investors are allocating their assets:
Fig 4 Asset allocation of Stanford Endowment
Comparing this to the typical asset allocation of an Irish multi-asset class fund in Fig 3 it is clear portfolio managers in Ireland need to lift their game and give Irish investors a more diversified exposure that will enhance return and reduce risk through the economic cycle. Since 1991 the Stanford Endowment has outperformed a similar passively invested bond and share portfolio by 4.70%pa. Or putting it another way your portfolio would almost be double the size it is today if you had your money invested with Stanford.
Our concept of diversification has become commoditized into only investing in liquid, daily priced and easily disposed of assets such as listed bond and equities. This narrows the range of investments available to investors, increases risk and reduces the potential returns. Long term investors and pension funds need to consider a wider range of assets to deliver a truly diversified portfolio return to investors.
Author: Frank Mulcahy, Editor and CEO of The FM Report.