When it comes to building portfolios, investors regularly hear about the importance of diversification*.

The basic principle is simple; by investing in a single asset, an investor is fully exposed to its individual risks.

By combining assets with different risk characteristics, it’s generally agreed an investor may be able to improve the risk and return profile of the overall portfolio*. 

Potentially, this could mean lower volatility, smaller drawdowns and better compounded returns.

*Diversification does not assure profit, nor does it protect against loss.

Sample Return SeriesThe return series shown are for illustrative purposes, and do not represent returns for Abbey Capital or any of the funds it manages.

Before we discuss ‘how’ diversification works, let’s explore ‘why’ diversification has long been a focus for investors and financial advisors. The answer lies in the way portfolio diversification has traditionally been approached.

Diversification – Equity / Bond Correlation

For most of the previous two decades, equity and bond markets have proved to be excellent portfolio companions. In any year where one experienced a negative outcome, the other provided a positive offset.

This period was notable for historically low interest rates, where the negative correlation between equities and bonds was only ever broken for very short periods.

That pattern has changed dramatically in this decade, as inflation has driven a major shift in global interest rate policy, and a persistent positive equity-bond correlation has emerged.

Annual Returns for Equities and Bonds: 2000 to 2023Source: Abbey Capital, Bloomberg. Equities are represented by the S&P 500 TR Index. Bonds are represented by the JP Morgan US Government Bond Index. Data is shown from 2000 to 2023 for illustrative purposes. The indices referred to herein are not based on the entire population of equities or bonds and are not indicative of the performance of any particular manager or fund. Furthermore, these indices may not be directly comparable. As a result, there are inherent limitations with using these indices for representative purposes and the above is shown for illustrative purposes only. No fund managed by Abbey Capital is benchmarked against any index, including the indices referenced. For an explanation of all indices referenced please go to the appendix.

We believe this change matters.

If a positive correlation between equities and bonds continues, it suggests they are more likely to make and lose money at the same time. This poses a real dilemma for investors, who have often relied on a negative equity-bond correlation to diversify portfolios.

Diversification – Why drawdowns matter

So why might smaller drawdowns and lower volatility be so important in managing portfolios?

The simple answer relates to capital preservation and drawdowns. And, more specifically, the reality of what it actually takes to recover from a drawdown.

An investor might consider the following:
Firstly, the size of return needed for drawdown recovery, and how it’s impacted by compounding.

Sample drawdowns, with return required to exit drawdownThis example is shown for illustrative purposes and is not based on the historical or expected drawdown profiles or returns of any asset or index. Results are purely hypothetical there was no actual trading or actual profits for these scenarios. No representation is being made that any account will or is likely to achieve profits or losses similar to these being shown. Please see the hypothetical performance disclaimer below for additional information.

For example, if a portfolio loses -10% having started with 100 USD, it needs a return of +11.1% on the remaining 90 USD to return to flat. This is compounding in action. To get back to the same number of dollars the portfolio started with, the percentage rate of return needed to exit a drawdown is larger than the drawdown itself.

The problem gets progressively worse as the size of the drawdown increases. Clearing a -20% drawdown requires a return of +25%, while a -50% drawdown means the returns need to make +100%, to get back to where the portfolio began.

Compounding may also affect the time it takes to recover from a drawdown.

The graph below shows how various sizes of drawdown, and subsequent recovery, might look for a portfolio that annualises at +8% return after its initial drawdown. As the starting drawdown becomes larger, it takes longer and longer to recover.

Sample drawdowns and the time required exit, assuming a 5% p.a. return This example is shown for illustrative purposes and is not based on the historical or expected drawdown profiles or returns of any asset or index. Results are purely hypothetical there was no actual trading or actual profits for these scenarios. No representation is being made that any account will or is likely to achieve profits or losses similar to these being shown. Please see the hypothetical performance disclaimer below for additional information.  

It is important to remember that typically investors don’t pay fees to have the value of their portfolios remain flat. They want a positive return on their investment.

Even if an investor demands a modest +5% annualised return, keeping pace can quickly become challenging.

As return expectations continue to compound year-on-year, so too does the time taken to chase down a target return. As we see, the challenge is enlarged by each increase in the size of initial drawdown. In risk management terms, this highlights the positive impact that limiting drawdowns and capital preservation can have in helping investors and financial advisors achieve their long-term investment goals.

So, what can investors do to minimise these types of risk? Focus on diversification*.

When assessing portfolio diversifiers, it’s important to ask some key questions about the assets being considered:

– What are their fundamental return drivers?

– Are these drivers likely to be different to those of equity and bond markets, particularly during periods of market stress?

*Diversification does not assure profit, nor does it protect against loss.

Effective diversification – understanding the asset mix

Understanding correlation is key to understanding diversification. Consider the following example:

The below chart shows the drawdown profile for US equities and a commonly used alternative asset class (which we will call Alt Strategy A) which has a +0.7 correlation to equities. The paths are sometimes different, but often very alike, indicating that they may be influenced by similar return drivers.

This is especially true during larger market corrections. When combined in an equal weighted portfolio, the improvement in portfolio risk (or max drawdown) is relatively small.

Drawdown profile for Equities and Alt Strategy A: January 2000 to April 2024

Source: Abbey Capital, Bloomberg. Equities are represented by the S&P 500 TR Index.  This example is shown for illustrative purposes and is not based on the historical or expected drawdown profiles or returns of any asset or index. Results are purely hypothetical there was no actual trading or actual profits for these scenarios. No representation is being made that any account will or is likely to achieve profits or losses similar to these being shown. Please see the hypothetical performance disclaimer below for additional information.

Now, compare this to a different scenario, where Alt Strategy A is replaced by a different alternative asset, which we call Alt Strategy B. The new strategy has exactly the same volatility as Alt Strategy A, but this time Alt Strategy B has a -0.1 correlation to equities instead of +0.7.

Immediately we see the paths of equities and Alt Strategy B are often different, and the impact on the drawdown profile of the combined equal weighted portfolio is significant. Its path is smoother and drawdowns shallower.

 Drawdown profile for Equities and Alt Strategy B strategy: January 2000 to April 2024

Source: Abbey Capital, Bloomberg. Equities are represented by the S&P 500 TR Index. This example is shown for illustrative purposes and is not based on the historical or expected drawdown profiles or returns of any asset or index. Results are purely hypothetical there was no actual trading or actual profits for these scenarios. No representation is being made that any account will or is likely to achieve profits or losses similar to these being shown. Please see the hypothetical performance disclaimer below for additional information.

Diversification can reduce the size and length of portfolio drawdowns*. It can also enhance a portfolio’s risk and return characteristics by reducing volatility and improving Sharpe ratio.

It’s not always possible for investors and advisors to know when they or their clients will need liquidity. Liquidity needs are driven by factors that are many and varied, both personal and portfolio related.

By focusing on underlying return drivers when assessing potential diversifiers, investors may better understand their correlation profile, potentially unlocking a valuable portfolio management tool. As our comparison suggests, a well-diversified portfolio can produce a smoother path and reduce the risk of being in a larger drawdown at exactly the time when that liquidity might be needed*.

In portfolio management, it highlights how the journey is just as important as the destination.

*Diversification does not assure profit, nor does it protect against loss.

Indices