Diversification has always been at the heart of asset management, but recent turmoil, from higher inflation to conflict, trade barriers and the AI revolution, is roiling markets. Can investors still reap its benefits?
Read this article to understand:
- The key tenets of diversification investors should think about
- How we are managing diversification and risk through disruptions
- Why difficult times can help investors prepare for the future
Since 1952 and Harry Markowitz’s foundational paper on modern portfolio theory, the notion that diversification is the only free lunch in investing has stood the test of time.1 Yet following Russia’s full-scale invasion of Ukraine in 2022, the inflation and interest rate regime has changed, upending a 30-odd-year negative correlation between bonds and equities.
Today, oil prices are seesawing with every change in the Middle East conflict, dragging inflation and interest rate expectations in their wake. Artificial intelligence is driving equities to dizzying heights, but hyperscalers are accumulating debt to concerning levels.2 The AI revolution is also raising questions about the future of several economic sectors. And as confirmed by President Trump’s recent moves to reinstate tariffs on friends and foes alike, protectionism is still on the rise.3
So is diversification still a free lunch, and can investors continue to find it in their portfolios?
To find out, AIQ has spoken to Edward Gladwyn, equities portfolio construction lead, Fraser Lundie, global head of fixed income, Nicholette MacDonald-Brown, global head of equity, and Sotirios Nakos, head of multi-asset portfolio management. In this Q&A, they unpack their views on diversification, the impact of global events and the tools and approaches they use to keep portfolios resilient.
Q: At a headline level, people think of diversification as between asset classes and across companies and sectors. But it can also apply to time horizons, asset maturities, geography, investment objectives and more. Can you unpack this?
Nicholette MacDonald-Brown (NMB): From an equity perspective, we would think about diversification through all those lenses, as concentration risk and diversification have always been a core part of our work. But we also think about diversification in two particular ways.
We think about it relative to the risk budget we’re given because the smaller your risk budget, the more important diversification becomes.
And we think about it from a people and diversity-of-thought perspective. We are a team of experts across a variety of industries, and we want to make sure our portfolios reflect the totality of that knowledge and expertise rather than a single view on a single topic.
Fraser Lundie (FL): As a firm, we are trying not to be constrained by silos, whether between fixed income and equities, in the way we interact with multi-asset, or across trading, portfolio management, risk, research, strategy and economics. Our fixed income matrix pods are designed to bring those different perspectives together, so that diversification is informed by a broader range of views rather than by any single lens.
In fixed income portfolios, the opportunity set is much broader than it used to be. Investors can now diversify across sub-asset classes that would previously have been regarded as niche, including emerging market debt, high yield, hybrids, loans and securitised credit. That means the starting point for diversification goes well beyond a traditional developed-market government bond and credit portfolio.
And this is probably relevant across asset classes, but current valuations are expensive. You could argue, therefore, that a greater share of total return may need to come from alpha, and from the contribution of active management, rather than from beta alone at this point in the cycle.
Sotirios Nakos (SN): From a multi-asset point of view, one question is how much you can diversify your beta, which is regime dependent. In 60-40 portfolios, the fiscal and inflation risks are more prominent than before COVID, so investors need to be specific about which part of the curve and credit asset classes offer the greatest diversification for the level of risk. We have to make that 40 per cent work harder.
And, while the macroeconomic background has been an important force, over the last six years, company earnings have been also a key driver. Within equities, it has become more important to consider the bottom-up view, blend different styles and not just track indices. There is an element of diversifying alpha, as well as beta.
Finally, the recent experience around energy security and disruption suggests there is more room for us to take some exposure to alternatives, whether through commodities or long-short strategies, to hedge some risks.
Edward Gladwyn (EG): Diversification is part of the toolkit, so we have to take a robust approach with two points to bear in mind.
One is to scrutinise whether we are getting diversification where we expect it. Buying more stocks or asking more people for ideas doesn’t necessarily deliver diversified views if there is stylistic overlap or different sectors are driven by the same underlying theme.
The other is that, as everything we do is benchmark relative, a lack of diversification is a tool to concentrate exposures we want to hedge out. For instance, if we have two stocks in the same sector, we may expect them to have the same underlying industrial driver. This driver can be hedged, allowing clean exposure to the company we consider to have a stronger profile. The danger is that, if the two companies’ underlying drivers diverge, we lose that concentration benefit and receive a diversification exposure we didn’t want.
AI is a good example, where something that seems highly concentrated is actually enormously diversified in terms of the performance of the underlying stocks.
Q: Indeed, AI and semiconductors are concentrating a lot of market value. Can you tell us more about this hidden diversification?
EG: It’s been a broad trade that hasn’t just affected the semiconductor complex. We’ve seen data-centre demand permeate across other sectors, notably within industrials. That’s required a lot of running to keep up with how these markets are evolving, to ensure we’re not over- or under-exposed to the trade overall, and to select the areas we think are most attractive.
To give you a contextual example, NVIDIA is the poster child of the AI trade beneficiaries, selling the underlying picks and shovels. But its performance year to date is in line with the broader market. Meanwhile, some of its peers have risen hundreds of percent.
That assumption of concentration has in fact shown huge dispersion and diversification potential, so we need to use a different lens to disaggregate the underlying drivers within what seems to be a large industry group. To do that, we move away from traditional industry definitions, to break down firms’ specific business and industrial sensitivity. For example, we want to pick our preferred memory exposure as opposed to playing the memory trade overall.
Q: At the same time, many of those firms are taking out a lot of debt. How does that impact your investment views?
NMB: We jointly conducted a big piece of work earlier in the year, looking at the difference between what was embedded in the debt and equity markets from a cash flow perspective. Within sensible levels of leverage, which most of these companies have, we’re happy for companies to tap debt markets to grow. But it’s about the expectations relative to what’s embedded in the instrument you’re looking at.
SN: The level of hyperscalers’ corporate issuance has been discussed a lot. From a multi-asset point of view, it’s about expressing preferences around where we think there’s greater upside to participate. By and large, we’ve invested in the AI theme through the equity market. That doesn’t mean there are no opportunities in credit, but they would have to be addressed from a bottom-up level, so from a multi-asset standpoint, it’s easier to access the theme through equities.
FL: This type of disruption cuts across a wide range of scenarios and does not sit neatly in either a top-down or bottom-up box. It affects individual issuers, sectors and broader market assumptions at the same time. In that environment, diversification means building portfolios that can remain resilient across multiple plausible outcomes, rather than relying on a single central case.
Q: Events in the Middle East are influencing inflation, interest rate and growth expectations. How does it affect your investment approach?
FL: Things seem to be changing more quickly than they used to, so portfolios need more dynamism. The distinction between strategic and tactical asset allocation is not disappearing, but the two need to be more closely connected: short-term shocks can affect long-term assumptions, while strategic views still need to discipline tactical decisions.
SN: Long-term risk models make assumptions about correlations and volatility between asset classes, but most assume a whole-business-cycle exposure. In a situation of supply disruption, correlations can change quickly, and you can’t just assume that the diversification benefit will remain as expected through the whole cycle. We are seeing this in energy, where having some exposure to US energy names has given portfolios a hedge. But there are other aspects. For instance, gold worked very well over the last couple of years, but this year, movements in the dollar have more than offset its performance.
Another point is that, if you start to notice these forces over the short term, they will slowly start to affect long-term discussions as well, whether through energy resilience, strategic autonomy or a multipolar world. It’s not just the long-term cycle informing the short-term decisions; it can work both ways.
EG: As a benchmark-relative, active equity, bottom-up led, stock-specific manager, we don’t want to see any impact on our investments from macro-led moves, and certainly not first-order impacts. And broadly speaking, that is what we saw when conflict broke out in the Middle East.
But more interesting is where assets become less diversified, giving visibility to what is driving the underlying market structure. What we saw were very large-scale, simplified reactions to the war and, notably for us, a huge sell-off on Europe. Investors concluded that Europe was more sensitive to energy supply disruption than the US, which is correct. But plenty of companies listed in Europe are not materially sensitive to the European economy. They are large, internationally exposed companies, but their stocks were much more impacted than those of their US peers with similar profiles. So, this large-scale reaction was a source of opportunity. But, as it was technically driven, within a couple of weeks most of those distortions corrected.
It was an interesting period in that it showed the benefit of diversification and of hedging out risks you don’t want in your portfolio. It also showed that there are clear periods of market inefficiency – which is what we try to exploit – even if, broadly speaking, the market is efficient and it doesn’t take that long for things to correct.
NMB: All this is why I would argue you need diversity of people and ideas, because what’s leading the market can change so rapidly. You need to have ideas on the shelf that you can move into quickly. That “supermarket” for fund managers is essential.
Q: Trade barriers, tariffs and protectionism are ongoing. How do you diversify for those risks?
NMB: Where a company is listed doesn’t indicate how it’s impacted by tariffs, so geographic diversification doesn’t necessarily mean you’ve achieved diversification from trade barriers. It is about understanding what you own and intelligently thinking about diversification.
FL: Again, top-down and bottom-up are much closer together than they used to be, and you cannot have one conversation without the other. You might think you are taking a sector view, for example on telecoms, but then find that parts of the sector are no longer exposed to the drivers you expected because technology and business models have moved on. The key is to understand how those exposures are evolving, so that an allocation that looks sensible from the top down still holds up when you examine the underlying companies.
SN: With trade, there is also an inflationary aspect to monitor closely. Energy has been market participants’ primary focus. But that doesn’t mean there are no risks associated with greater hurdles to trade. In terms of the inflation expectations, one could argue the associated risk premium will be higher than it was in a globalised world.
Q: Has it become harder to diversify portfolios, or is it business as usual for investments?
FL: Factually, it has become harder since the inflation regime changed in 2022, because investors can no longer rely quite as heavily on the negative correlation between rates and risk assets. But the toolkit has also expanded. Diversification can be rebuilt by broadening the fixed-income opportunity set, combining top-down and bottom-up insight across asset classes, and being more dynamic in portfolio construction.
SN: All else being equal, you need to spend more time thinking about portfolio construction – not just on idea generation, but on how each idea complements the portfolio. And you need to do that not only on a tactical but also strategic basis, to address the big questions that will drive meaningful change in portfolios. For example, if in my correlation matrix all the correlations are slightly higher, my allocations might need to change significantly.
Where it’s gotten somewhat easier is on cautious portfolios. For years, it was difficult to provide enough returns, whereas in the current environment, it’s possible to create attractive portfolios with reasonable yield and low volatility, particularly if you take advantage of the alpha opportunities that exist across certain sub-asset classes.
NMB: Across asset classes, the toolkits we have built for our investment teams, from portfolio managers to desk heads and analysts, have the ability to drive better performance from here.
Moreover, for years, markets have been very narrow, making it tough to outperform and show the benefits of diversification, but that is starting to change. Five years ago, we would not have been talking about AI being the main driver of markets, and investors weren’t set up to deal with it. What will drive markets from here is the known unknown; it’s the thing we’re not talking about today, but of which you need an awareness so that, as it grows and changes, you can benefit.
EG: Diversifying feels harder, with relationships less stable, but the analytical frameworks and tools that has forced us to create should make the next iteration easier. We’re sowing seeds for the future through the difficult times.
A free lunch, but a working one
In a disrupted landscape, securing real diversification requires investors to understand the underlying assets, connect top-down, bottom-up, tactical and strategic views, and keep a range of ideas ready to implement as markets evolve. Fixed income opportunity sets have broadened, cautious multi-asset portfolios can now access more attractive yields, and dispersion across markets is creating opportunities for active management to contribute a greater share of total return. With the right tools and approaches, investors can still reap the benefits of diversification.
