Eight years ago, the financial crisis crippled the American banking industry, and the devastating effects rippled across the world. It is now a globally accepted fact that top world governments, central banks, economists, investment bankers and financial journalists were all caught off-guard by the nature and extent of the crisis and this led to a massive fallout across all asset classes.
The situation began to ease out by 2010 and since the beginning of 2012, the markets have witnessed a bullish period, with most asset classes reporting strong gains fuelled by an economic recovery. However, in the past six months, the global markets began to witness significant spikes in volatility on the back of concerns over an economic slowdown in China that had a cascading effect on the global economy as the country contributes nearly one-third to global growth.
Further, the situation has worsened to an extent that many economic pundits are already predicting another crisis down the line. Gladly, this time, the global economic community, particularly the central banks, seems to be better prepared to tackle any downturn in the near future. Likewise, it will be prudent for global investors to also take necessary steps to safeguard their portfolios against uncertain times ahead.
One such risk mitigating strategy is portfolio diversification involving alternative asset classes. Historically, traditional asset classes, equity and bonds, generally move in tandem during uncertain periods, making the overall portfolio increasingly vulnerable to market movements.
On the contrary, alternative asset classes that include venture capitalist, private equity, hedge funds, real estate, commodities, etc have low correlations with equities and bonds, and therefore can produce a good risk adjusted return over a reasonable time period, while reducing the overall risk and volatility of the portfolio.
For instance, an analysis of asset class performance during the past two years clearly indicate that alternative investments such as real estate and gold have outperformed most traditional asset classes under coverage.
To understand this better, let us consider a couple of investment cases:
In Case A, we have a traditional portfolio with 60:40 split between Equity and Bonds, respectively.
In Case B, we have a diversified portfolio with 40:20:40 split between equities, bonds and alternative asset classes particularly real estate and gold.
During this period, investment in Case A would have yielded a negative return of 16.5 per cent while a more diversified investment portfolio in Case B would have a relative outperformance to Case A by approximately 10.5 per cent.
Of course, this is a simple example and alternative investments in the real world are far more complicated, however, these cases do illustrate the importance of a diversified portfolio and how investors can minimise their risk during volatile times.
Given the current market volatility and rising concerns over an uncertain macroeconomic environment, interest rates and inflation, it will be wise for investors to bring in the sophistication and diversity into their portfolios and review the role of traditional asset classes in future portfolio construction.
Further, alternative investment products have a non-traditional approach which enables them to invest in areas and ways traditional investments cannot, thereby improving the overall risk-return characteristics of a portfolio.
Moreover, since the 2008 crisis, the sophistication of alternative investment products have also evolved drastically and they are more conducive for a broader universe of investors as compared to a decade ago, wherein such offerings were limited and mainly reserved for institutions and high net worth individuals. Further, this evolution is likely to continue going forward, driven by the need to differentiate in a competitive environment.
Now that we have established the importance of a diversified portfolio, it is equally important to understand the limitations of alternative asset classes and the way forward.
Firstly, alternative investment strategies often require a longer term commitment compared to more traditional portfolios, which can be liquidated at the investor’s discretion.
Secondly, given the non-traditional investment approach, it is always advisable to seek services of professional asset management firms while drafting an alternative investment strategy. Although the fee structure of asset management firms can be on the higher side as compared to a simple brokerage or commission in the case of traditional portfolios, their advice is often worth the money spent.
In conclusion, portfolio diversification is the first line of defence in reducing overall investment risk, especially during volatile times. Spreading your funds across different asset classes can reduce the impact of an unexpected fall in one of them. Further, it is equally important to seek professional advice while drafting an alternative investment strategy. - gulfnews
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