How to safely diversify in volatile marketsPUBLISHED : | UPDATED:
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Cross-asset correlations globally over the past five years are about double what they were in the early 1990s (A correlation of 100pc indicates that, as the price of one particular asset rises by $1, so will the price of another). Photo: Rob Homer
Minimising risk has never been more important for investors worried about losing out in a crisis. As global economic events batter financial markets, investors need to look for alternative baskets in which to spread their eggs:
1. The new rules of diversification
The idea behind this strategy is to spread your money across assets for which prices don’t move in lockstep. It’s about finding the right risk/return trade-off – not about the highest possible return. You want to avoid situations where a single event could wipe out your entire portfolio.
2. Correlation counts
This is the degree to which asset prices move together. A correlation of 100 per cent indicates that as the price of one particular asset rises by $1, so will the price of another. Cross-asset correlations globally over the past five years are about double what they were in the early 1990s, say JPMorgan analysts. By the time Lehman Brothers collapsed in late 2008, commodities, which had been negatively correlated with equities, became positively so.
3. Alternative appeal
The idea of spreading your risks was not killed off by the global financial crisis but taking this approach is more difficult. Alternatives have become popular as investors seek true diversification.
4. Food for investor thought
Agricultural commodities appear to be a good bet with attractive dynamics: that is, the scarcity of land and the changing and improving diets of the massive emerging middle classes in China, India and other emerging nations. These so-called soft commodities form a core part of inflation, so they are a hedge against rising prices.
But be warned, savvy investors: while the long-term outlook for consumption of agricultural commodities is a promising one, the supply of these products relies heavily on a big unknown: that is, the weather. So it makes sense to be careful how you tread in investing over the short term.
5. Oil opportunities
Raw material prices rise and fall with the economic cycle. Oil marches to the beat of its own geopolitical tune. At a time when global growth is heavily depressed, a potential conflict in Iran has raised the prospects of supply shortages and sent the oil price sky high.
6. Building on infrastructure
An asset providing reliable, inflation-linked cash flows can anchor your portfolio. You’ll generally need to hand over your money to a professional to get exposure to unlisted assets like toll roads. A listed company like Toll Holdings (TOL) has the right assets but its shares will follow the broader market.
7. Hedge funds
“Absolute return” mandates should mean such funds produce positive returns through the cycle. Luckily, potential investors in these funds have some solid historical evidence to identify the hedge funds which can help diversify your portfolio.
8. Gold shines on
The yellow metal has racked up over a decade of straight annual gains, proving its worth as a great diversifier in uncertain times. It’s perceived as the ultimate store of value and is attractive to those afraid that developed countries are debasing their currencies, which will lead to rampant inflation. More generally, it’s the safe haven status accorded to it that makes gold almost crisis-proof.
9. How to play it: ETFs and ...
Exchange-traded funds are one of the few ways for individuals to play the food and oil themes. BetaShares offers an Agriculture fund (currency hedged) that tracks an S&P index. That index has a 38 per cent exposure to corn, 27 per cent to wheat and 19 per cent each to soybeans and sugar. BetaShares also has a Crude Oil Index ETF, which is hedged for currency. For gold investors, ETF Securities offers an unhedged gold ETF, or for a hedged fund you can go with BetaShares again.
10 ... CFDs
Contracts for difference provide a way for you to access a remarkable array of markets. CFDs are particularly useful for taking advantage of short-term volatility. Be aware that you are not investing directly in the underlying asset, because CFDs are derivative products, and that they are usually heavily leveraged.
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|Asset class||Correlation between…||1990-95* (%)||Past 5yrs (%)||Change|
|Equity||DM** country indices||31||47||17|
|Equity||EM** country indices||23||45||23|
|Equity||DM and EM indices||38||74||36|
|Credit||High yield and equities||46||64||19|
|Forex||DM currencies and equities||-1||28||29|
|Forex||EM currencies and equities||6||42||36|
|Interest rates||10-year rate and equities||-38||29||67|
|Commodity||Commodities and equities||-5||12||17|
Patrick Commins Smart Investor