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What does good diversification look like?

September 2018

Diversification used to be easy. Investors just had to mix equities and bonds. Not so today, as the influence of passive funds and monetary policy weighs on markets. 

  • There are now more indices than stocks, and the average stock is included in 115 indices
  • Events in one area are impacting unrelated areas because they are in the same index
  • The old diversification rules no longer work and investors have to be more nuanced in their thinking

Diversification has become more difficult. Not only have stocks and bonds started to show greater correlation, thanks to the ebb and flow of monetary policy, but the extreme rise of ETF has also made it more difficult to find diversification. 

The Miton multi-asset team point out that in the US, there are now more indices than stocks, and the average stock is included in 115 indices. That makes it difficult to find uncorrelated investments. It points to the example of Chinese tech giant Tencent, which reported weaker-than-expected earnings last week.  

It said: “The stock fell approximately 4%, which is reasonable, and investors in China and the technology sector struggled, also reasonable. However, Tencent is also 5% of the Emerging Markets ETF which fell almost 3% on the day, meaning investors in India, Brazil and South Africa also suffered as capital flowed out of these emerging markets because a technology stock in China had bad results. Events in one area are impacting unrelated areas elsewhere simply because they’re in the same index.”

This shows one of the ways in which the old diversification rules no longer work and investors have to be far more nuanced in their thinking around diversification. This may become increasingly important as interest rates rise and liquidity is withdrawn from the system. Finding those assets that are not interest-rate sensitive, for example, will be tough.  

The growth of ETFs is also having an impact on valuations: There is a relationship between a stocks’ valuation and the number of indices in which it appears. Stocks that are more widely owned by ETFs tends to trade at a valuation premium. This makes sense, as there are more buyers for the company. While this can be supported as money flows into passive funds, that over-valuation might be laid bare were that to reverse. 

This is another way in which valuations are deviating from fundamentals. What is not clear is the extent to which this is temporary. Active managers believe that share prices follow fundamentals in the end, but as the influence of passive management increases, will this still be true? Understanding the influence of these forces on investor portfolios will be vitally important as the market climate shifts.

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