While diversification is a vital tool for protecting clients’ investment portfolios, a new report from Mercer has suggested that market uncertainty means advisers need to be careful to avoid “hidden correlations” that ultimately reduce the effectiveness of traditional diversification strategies.
In particular, the report noted the “extraordinary levels of market concentration” in the “Magnificent Seven” tech stocks, as well as the unusual positive correlation between equities and bonds that has seen them moving in the same direction at the same time.
To combat this, Mercer suggested advisers need to work to create “genuine diversification” by spreading risk across asset classes, sectors, geographies and strategies that “do not move in tandem” with the aim of reducing overall portfolio volatility.
Rebecca Jacques, Mercer’s head of wealth management investment solutions, suggested that liquid alternative funds – or liquid alts – could be an effective solution for advisers navigating these challenges.
Describing them as “next-generation diversifier”’, the report explained that integrating these non-traditional assets into client portfolios can help advisers create more “genuine” diversification, though it also pointed out that these assets are not without risks themselves.
While advancements have made it easier for retail investors to access alternative assets in recent years, providing them with a greater array of opportunities, the firm noted that advisers still need to be mindful when creating portfolios, ensuring they aren’t unwittingly putting them at greater risk during these turbulent times in the market.
“Investors may be less diversified than they realise. Advisers will need to understand how the underlying assets in a portfolio correlate and interact with one another,” the firm said.
“Advisers are encouraged to clearly define strategies they can implement with each asset class and allocation.
“It is important to consider alignment with active managers who possess deep expertise in the relevant markets – whether those are emerging markets, private credit or infrastructure assets.”
Though creating “genuine” diversification is essential for the longevity of investment portfolios, the report explained, it is still important to remind clients that short-term underperformance is still possible, however, diversification should see it smooth out over the long term.
Meanwhile, Mercer concluded that there are still options available to unlock alpha and diversification, even in these challenging times, however, it is an “increasingly delicate balance between risk and opportunity”.
