Navigating the New Normal: Rethinking Diversification in 2025
The investment landscape is becoming increasingly complex, making it harder to shield portfolios from market volatility. For financial advisers, the old rules of diversification may no longer be enough to protect their clients' wealth. As major economic shifts and new market dynamics take hold, a deeper understanding of what lies "beneath the hood" of a portfolio is more crucial than ever.
A key challenge has been the unusual convergence in the performance of equities and bonds. In 2022, for instance, both asset classes saw a simultaneous downward trajectory, largely influenced by persistent inflation and rising interest rates. This has undermined the traditional diversification strategy of relying on bonds to cushion a fall in equities. Compounding this issue is the extraordinary market concentration in a handful of "magnificent seven" tech stocks, which makes it more difficult for actively managed funds to outperform.
What Does Genuine Diversification Look Like Now?
In this new environment, achieving genuine diversification requires looking beyond a simple mix of stocks and bonds. Advisers are increasingly considering a broader range of uncorrelated assets to build more resilient portfolios. This has led to a greater focus on alternative investment strategies such as private credit, infrastructure, and hedge funds.
These alternatives, however, come with their own set of challenges, including potential liquidity constraints and complexity. One avenue that has gained traction is liquid alternative funds, or 'Liquid Alts'. These funds offer exposure to non-traditional assets like commodities and renewables, which can help provide true diversification when blended with private market investments. However, they can be complex, often using derivatives and synthetic instruments, which requires careful due diligence to ensure they align with a client's risk appetite and goals.
The Real Cost and Hidden Risks of Diversification
While new products like actively managed ETFs and REITs have made alternative assets more accessible, they are not always a simple substitute for traditional holdings. Advisers must clearly define the purpose of each asset in a portfolio. For instance, if the goal is downside protection, Liquid Alts might be a better fit than private debt, which may be more suitable for achieving alpha. It's also important to recognize that while diversified strategies can smooth out long-term returns, they might underperform in the short term, making it essential to manage client expectations.
A significant risk in modern portfolio construction is unintentional concentration. A portfolio might appear diversified on the surface but could have hidden exposures that compound risk. For example, investing in next-generation infrastructure like data centers may seem like a diversification play, but their performance is closely tied to the very tech giants investors might be trying to diversify away from. A downturn in the tech sector could have a ripple effect, reducing the intended diversification benefits.
This is also true for geographic diversification. For Australian investors, what might seem like a strategic allocation to emerging markets could, in reality, overlap with existing exposures. The Australian economy and currency are already influenced by Asia, particularly China, meaning additional investments in these areas might not offer the expected diversification.
The Way Forward: Peel Back the Layers
As the investment world evolves, advisers must look deeper into portfolio construction. It is no longer enough to simply allocate across broad asset classes. A thorough understanding of how underlying assets correlate and interact is essential. By carefully defining strategies for each allocation and partnering with active managers who have deep expertise, advisers can still find opportunities for alpha and diversification. The key is striking a delicate balance between risk and opportunity in this new, more complex landscape.
Reference:
Mercer. (2024). Top investment considerations for financial advisers 2025. Mercer (Australia) Pty Ltd.
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