The potential benefits of diversification
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- Asher Kelly
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1 The potential benefits of diversification
2 The case for diversification Over the past few years, pension schemes have faced challenging market conditions and investment performance has been mixed, leading to worrying funding positions for many UK schemes. In the past, pension funds may have relied on the performance of equities to deliver them strong, consistent returns but recent history has shown that it is increasingly difficult to generate positive returns by investing in a single market or type of investment like stocks and shares. No investor, regardless of investment experience, can consistently predict the following year s top performers. The chart below shows the annual performance of different asset classes ranked in descending order, over the past 10 years. It is clear that different asset classes have traded places in the spotlight, moving in and out of favour with changes in the global economic cycle. Commodities for example were the worst performing asset class in 2001, but the best performing one the following year. No one asset class consistently outperforms picking the right one is very difficult Worse Better % 32.1% 51.6% 36.9% 30.3% 41.4% 36.5% 1.0% 74.5% 22.9% 4.4% 29.0% 41.5% 22.4% 25.6% 33.7% 32.7% -19.1% 58.2% 16.4% 0.6% 6.2% 38.5% 20.9% 15.9% 29.2% 13.9% -26.2% 35.8% 15.1% 0.5% 3.0% 33.8% 17.3% 10.0% 20.7% 12.6% -38.5% 34.2% 12.8% -4.9% -1.4% 29.0% 15.7% 9.4% 13.9% 12.5% -40.3% 30.8% 12.3% -13.0% -8.0% 26.4% 15.2% 7.6% 13.6% 9.6% -46.2% 23.5% 10.9% -16.5% -18.4% 25.7% 11.1% 3.0% 11.8% 3.5% -46.4% 18.6% 9.0% -19.9% -19.5% 20.7% 9.6% 2.7% 11.8% 1.9% -46.5% 13.5% 3.9% -31.9% -23.4% 15.4% 9.0% -9.0% -15.1% -8.3% -54.5% 10.4% -4.5% Global Property Emerging Equity Commodities US Equity US High Yield Bonds Global Equity Hedge Funds European Equity Euro Debt Source: Bloomberg. Indices: Property GPR G250 Global; Emerging Markets Equity MSCI EM; Commodities S&P GSCI Total Return; US Equity - S&P 500; High Yield - Barclays Capital US Corporte High Yield; Global Equity MSCI World; Hedge Funds - Dow Jones Credit Suisse Hedge; European Equity - MSCI Daily TR Net Europe USD; Euro Dept - Barclays Capital Euro Aggregate total Return. This is not a complete overview of all asset classes and the selected asset classes mentioned are not meant to be representative of all asset classes. The informantion is shown for illustrative purposes and must not be misconstrued as research. Past performance is not indicative of future returns which may vary. Indices are unmanaged and do not reflect the deduction of management fees, brokerage or other commissions, exchance fees or any other expenses a client would have to pay. Investors cannot invest directly in indices. We believe diversification spreading the investment risk across different markets, types of investment and companies with different styles is key to obtaining more stable and robust returns and to minimising risk over the long term. Goldman Sachs Asset Management 2
3 Over the last few years we have witnessed what is termed increased correlation among traditional asset classes such as equities and bonds. This means that in tough economic times, they have behaved in a similar manner and all delivered lower returns and increased volatility, i.e. fluctuations in their value. At the same time alternative investment strategies such as property, high yield bonds, infrastructure and hedge funds, which are expected to deliver higher returns over the medium term, have developed. In an environment where the requirements of meeting pension liabilities have risen sharply and where pension schemes have historically relied on equities to generate returns, trustees may well have questioned past wisdom and sought to enhance portfolios through increased diversification, ultimately building a greater source of wealth to draw from when needed. Is diversification the only free lunch in investment? The old saying about not putting all of your eggs in one basket is especially true when it comes to investing. In our view, a properly diversified portfolio should include a range of asset classes; for example from both the UK and abroad: equities of different sectors and capitalisations; bonds with varying maturities; alternative investment assets such as private equity and commodities, and even cash instruments like money markets. Diversification can help reduce overall portfolio risk if a single investment is not performing well, its performance should be balanced by other investments which are doing better at that time. A diversified portfolio delivers stronger potential returns over the long term As of 30-Jun-11, a more diversified portfolio resulted in approximately US$2.5 mn more in accumulated wealth then a less diversified portfolio (Hypothetical US$250,000 investment beginning in 31-Dec-72 1 ) 12 More Diversified 2 Less Diversified 2 US$11.3 mn 10 S&P 500 Index BarCap Aggregate Bond Index US$9.3 mn US$8.7 mn (US$ mns) US$5.0 mn Jun-11 Source: GSAM, Ibbotson. 1 Chart shows monthly data points from 31 December 1972 through 30 June 2011 and includes monthly rebalancing. 2 Simulated performance results do not reflect actual trading and have inherent limitations. Any changes will have an impact on the hypothetical historical performance results, which could be material. Hypothetical performance results have many inherent limitations and no representation is being made that any investor will, or is likely to achieve, performance similar to that shown. In fact, there are frequently sharp differences between hypothetical performance results and the actual results subsequently achieved. Portfolios are comprised of underlying indices. Goldman Sachs Asset Management 3
4 Although hindsight is 20/20, history can teach investors valuable lessons. It tells us that when times are bleak and the market is receding, investors need to resist the urge to move too soon and abandon a well-diversified investment strategy. Key messages: History has proven that less diversified strategies that are missing exposure to the full spectrum of asset classes, including less traditional ones such as commodities and high yield bonds ultimately do not create or sustain long-term wealth for investors. Diversification across different investment styles, geographic regions, and capitalisations can enhance pension fund returns and help to reduce volatility and manage risk in the long term. The task of diversifying has recently become more complicated as asset classes have become more correlated and have in general underperformed. However we still believe diversification is a very useful tool for reducing portfolio volatility without sacrificing returns. Planning an asset allocation Investors are often surprised to learn that a significant percentage of the volatility of investment performance is driven by asset allocation decisions combining asset classes such as equities, bonds and cash in varying proportions within one customised, diversified investment portfolio. Factors such as when investors commit assets and which securities they buy are considered to have a relatively small impact on long-term investment results. Asset allocation strategies are key drivers of investment results Security Selection 4.6% Asset Allocation 91.5% Market Timing 1.8% Other Factors 2.1% Source: Brinson, Hood, Beebower. Determinants of Portfolio Performance. Financial Analysts Journal. July-August 1986; Brinson, Singer, Beetbower. Determinants of Portfolio Performance II: An Update. Financial Analysts Journal. May-June Goldman Sachs Asset Management 4
5 Asset allocation is the process of developing a customised, diversified investment portfolio by strategically mixing different asset classes in varying proportions. Asset allocation is based on the principle of diversification, but takes the process one step further. Diversification spreads money across different investments. Asset allocation, by strategically diversifying a portfolio among different asset classes, potentially offers investors a double advantage: to benefit from changing market cycles to reduce overall portfolio risk by offering a higher degree of diversification Asset allocation therefore aims to reduce the ups and downs associated with investing and makes it easier to stick with investors long term investment objectives and avoid market timing. When deciding on the asset allocation of a pension fund, it is essential for trustees to discuss the pension scheme s: 1. Goals What are the scheme s long-term income objectives? Is the scheme ready to take tactical decisions to change its asset allocation in order to achieve long term goals? 2. Time Horizon There are different opinions on how often trustees should review the scheme s asset allocation. The main objective for trustees is to make sure that their scheme meets its liabilities over time. Trustees should seek to balance longer term objectives with shorter term considerations. We believe an allocation time horizon of 3 to 5 years would be the minimum to give the asset allocation the opportunity to work through market cycles. 3. Risk Tolerance One of the toughest decisions trustees have to take is about the scheme s risk attitude. Trustees and sponsor/employer have to agree on how much risk they are ready to take in order to generate return. For example, a closed scheme that is close to fully funded will have very different asset allocation needs to an open scheme with a significant deficit. The credit crisis, the recession, and the current volatile market conditions have made the sponsor covenant risk an issue of increasingly important concern for pension trustees. The increased vulnerability and insolvency of many sponsoring employers have made trustees recognise the importance of identifying covenant risks and periodically carrying out covenant assessment and monitoring. The pension scheme s asset allocation should result from an overall process of balancing the scheme s goals, time horizon and risk tolerance. Goldman Sachs Asset Management 5
6 How to choose a portfolio Below we have put the theory into practice by outlining a sample portfolio which invests in a wide range of asset classes, sectors and countries. A diversified portfolio which invests in asset classes that are expected to react differently to any set of market conditions is likely to have lower volatility than a concentrated portfolio since extreme peaks in any given asset class will be lessened by the other asset classes which are not impacted. It should always be personally tailored to the individual characteristics of the scheme, taking into account factors like maturity of pensioners, funding levels, strength of sponsor covenant etc. We will look into this in greater detail in future pieces. Sample portfolio Real Estate Infrastructure UK Fixed Income (Liability matching) Commodities Global High Yield Emerging Markets Equity Emerging Markets Debt Private Equity Alternatives/ Hedge Funds Global Equity These examples are for illustrative purposes only and are not actual results. If any assumptions used do not prove to be true, results may vary substantially. The sample portfolio reflects GSAM Global Portfolio Solutions strategic assumptions as of a certain date. Strategic long-term assumptions are subject to high levels of uncertainty regarding future economic and market factors that may affect future performance. They are hypothetical indications of a broad range of possible returns. We believe that reducing volatility by putting in place a diversified asset allocation model should help pension schemes achieve their long term investment goals. Goldman Sachs Asset Management 6
7
8 This material is provided for educational purposes only and should not be construed as investment advice or an offer or solicitation to buy or sell securities. THIS MATERIAL DOES NOT CONSTITUTE AN OFFER OR SOLICITATION IN ANY JURISDICTION WHERE OR TO ANY PERSON TO WHOM IT WOULD BE UNAUTHORISED OR UNLAWFUL TO DO SO. Prospective investors should inform themselves as to any applicable legal requirements and taxation and exchange control regulations in the countries of their citizenship, residence or domicile which might be relevant. Past performance is not indicative of future results, which may vary. The value of investments and the income derived from investments can go down as well as up. Future returns are not guaranteed, and a loss of principal may occur. This material has been prepared by GSAM and is not a product of the Goldman Sachs Global Investment Research. The views and opinions expressed may differ from those of the Global Investment Research or other departments or divisions of Goldman Sachs and its affiliates. Investors are urged to consult with their financial advisors before buying or selling any securities. This information may not be current and GSAM has no obligation to provide any updates or changes. Simulated performance is hypothetical and may not take into account material economic and market factors that would impact the adviser s decision-making. Simulated results are achieved by retroactively applying a model with the benefit of hindsight. The results reflect the reinvestment of dividends and other earnings, but do not reflect fees, transaction costs, and other expenses, which would reduce returns. Actual results will vary. References to indices, benchmarks or other measures of relative market performance over a specified period of time are provided for your information only. Indices are unmanaged. The figures for the index reflect the reinvestment of dividends but do not reflect the deduction of any fees or expenses which would reduce returns. Investors cannot invest directly in indices. High-yield, lower-rated securities involve greater price volatility and present greater credit risks than higher-rated fixed income securities. Emerging markets securities may be less liquid and more volatile and are subject to a number of additional risks, including but not limited to currency fluctuations and political instability. Opinions expressed are current opinions as of the date appearing in this material only. No part of this material may, without GSAM s prior written consent, be (i) copied, photocopied or duplicated in any form, by any means, or (ii) distributed to any person that is not an employee, officer, director, or authorised agent of the recipient. This material has been communicated in the United Kingdom by Goldman Sachs Asset Management International which is authorised and regulated by the Financial Services Authority (FSA) Goldman Sachs. All rights reserved OTHER.MED.OTU
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