The case for diversification

It has long been said that diversification is the only ‘free lunch’ in investment and it can be achieved by including different assets to help to reduce the volatility of a portfolio.  The ‘can’ here is the key point: the benefits of diversification, will only be achieved if the assets move somewhat independently of one another. As an example, if a committee is made up of a group of people with identical opinions it would be no better than simply relying on the judgement of one of them as each is bringing the same insight or perspective and there is no diversity of opinion. The same can be said for investment: assets must bring elements of differentiation to improve the portfolio as a whole.

One of the key benefits of diversification is that it helps prepare investors, as far as possible, for the wide range of possible outcomes in markets. As none of us knows what the future holds, it is therefore sensible to spread out the risk of our investments to ensure, as the old saying goes, that we do not have all of our eggs in one basket.  

We in the Jupiter Independent Funds Team believe it is advantageous to construct portfolios as a blend of assets, each providing a different volatility profile, creating various sources of return generation due to their different geographic, sector, industry, market cap or other risk and return characteristics. Combining these assets can help reduce the diversifiable risk, leaving only the aggregate risk exposure of the portfolio as a whole and the unique characteristics of each underlying asset, weighted according to their size. These truly unique characteristics of individual assets are often termed idiosyncratic risks and can only be minimised by having smaller weightings in individual positions.

The issue for investors in today’s market environment, which we in the Jupiter Independent Funds Team perceive, is that at the index level, markets are becoming increasingly skewed towards certain areas. The result of this is that it potentially reduces the diversification benefits that broad market indices may be offering, leaving investors potentially exposed to more volatile returns, hinged upon fewer assets which dominate their portfolio. Within equities, looking at the various areas where diversification can act in one’s favour, we see distinct concentration where diversification could exist.

If we compare the geographic positioning of the MSCI World index to the average positioning of the equity exposure across the Jupiter Merlin strategies¹ we find the following:

Clearly the MSCI World index is dramatically skewed towards North America. Partly this is due to the US being at the centre of global capitalism and a home to many of the world’s best companies; partly because many dynamic companies seek to and do list there; and partly this is a reflection of the capital appreciation, particularly over the last 10 or 15 years, of companies listed in the US market.  However, we are now at a point where this concentration is extreme and the benefits of international diversification are potentially not being taken advantage of by investors in passive portfolios. The Jupiter Merlin portfolios on the other hand have significant exposures across each of these geographic areas.

When we look at sectors, again it is a similar picture, the winners which have propelled markets in recent years, particularly Technology, are now a significant bias at the index level, whereas the Jupiter Merlin strategies, which retain material technology exposure, have taken a more diversified approach.

 From a market capitalisation point of view the biases are again clear. 

Seasoned market practitioners will remember a time when people used to talk about ‘the small cap effect’: a dynamic where small caps tended to outperform large caps over time. This dynamic has not held for most of the last decade, due to the strong performance of mega-cap, predominantly US, technology stocks, but were it to return, many flagship market indices would not offer much benefit from the dynamic.

Finally, when it comes to idiosyncratic risk, as mentioned earlier, there are risks which cannot be diversified away and can only be reduced through position sizing. Here again investors in indices could be at a potential disadvantage due to the levels of index concentration we are seeing. At the top end of the MSCI World Index, we find household names, the largest companies in the world, NVIDIA, Apple, Microsoft, Amazon and Alphabet, but their success has led them to have chunky individual weights, in aggregate making up over 21% of the MSCI World Index. Of those five listed, only Alphabet is present as a top 5 company across the Jupiter Merlin range and on average, the largest 5 individual equity positions across the Jupiter Merlin strategies make up only 5% of the equity exposure, materially reducing the idiosyncratic risk of any individual position.

Like everyone else, we do not have a crystal ball to tell us what will happen in the future; perhaps the trend of US and Technology outperformance will continue for years to come and the current stock-market leaders will remain the winners. However, if financial history is any guide, there is a significant chance that the future will look different and we may see rotations in markets and leadership, with returns coming from different companies and areas.  In fact, looking at the performance of the Jupiter Merlin portfolios over the last couple of years, we would suggest a rotation in markets may have already begun.  As such, now more than ever, we believe that being diversified is a vital way to create robust portfolios which can face the future confidently and simultaneously offer the potential for attractive returns for clients.

For those looking for portfolios diversified broadly while embracing a range of opportunities in global markets, the Jupiter Merlin strategies are tailored to clients with various risk tolerances and we believe offer compelling prospects as a one-stop-shop solution.

Many quote diversification as the key reason they invest in multi-asset funds. The current levels of geographic, sector and individual-company concentration in index funds may be a key factor to consider when investors reassess their preferences. Going by the long-held wisdom about spreading out one’s investments to reduce risk, active strategies with diversified portfolios may be the way forward.

Fund Risks

For a more detailed explanation of risk factors, please refer to the “Risk Factors” section of the Scheme Particulars.

All of the Jupiter Merlin portfolios carry the following fund risks:

• Currency (FX) Risk - The Fund can be exposed to different currencies and movements in foreign exchange rates can cause the value of investments to fall as well as rise.
• Pricing Risk - Price movements in financial assets mean the value of assets can fall as well as rise, with this risk typically amplified in more volatile market conditions.
• Derivative risk - the Fund may use derivatives to reduce costs and/or the overall risk of the Fund (this is also known as Efficient Portfolio Management or “EPM”). Derivatives involve a level of risk, however, for EPM they should not increase the overall riskiness of the Fund.
• Counterparty Risk - the risk of losses due to the default of a counterparty e.g. on a derivatives contract or a custodian that is safeguarding the Fund’s assets.
• Charges from capital – Some or all of the Fund’s charges are taken from capital. Should there not be sufficient capital growth in the Fund this may cause capital erosion.

Additionally, Jupiter Merlin Balanced Portfolio, Jupiter Merlin Conservative Select, Jupiter Merlin Income Portfolio, Jupiter Merlin Monthly Income Select, and Jupiter Merlin Moderate Select, Jupiter Merlin Income & Growth Select have the following fund risks:

• Interest Rate Risk - The Fund can invest in assets whose value is sensitive to changes in interest rates (for example bonds) meaning that the value of these investments may fluctuate significantly with movement in interest rates e.g. the value of a bond tends to decrease when interest rates rise.
• Credit Risk - The issuer of a bond or a similar investment within the Fund may not pay income or repay capital to the Fund when due

Furthermore, Jupiter Merlin Balanced Portfolio & Jupiter Merlin Growth Portfolio have the following fund risk:

• Liquidity Risk - Some investments may be hard to value or sell at a desired time and price. In extreme circumstances this may affect the Fund's ability to meet redemption requests upon demand. 

Footnote

¹Includes Jupiter Merlin Worldwide Portfolio; Jupiter Merlin Balanced Portfolio; Jupiter Merlin Income Portfolio; Jupiter Merlin Growth Portfolio; Jupiter Merlin Conservative Select; Jupiter Merlin Income and Growth Select; Jupiter Merlin Moderate Select and Jupiter Merlin Monthly Income Select