New research by Towers Watson, the professional services firm, has found that although many pension funds and institutional investors still rely on equities to generate their returns, in reality a diverse portfolio of assets, combined with better risk management, can boost risk-adjusted returns by 20 to 40 per cent compared with the traditional bond/equity mix.
But a diversification strategy is no free lunch. During the financial crisis most risky assets collapsed in price but to different degrees and with some exceptions. In the past year returns have also varied. For example, developed market equities actually returned a negative 19.8 per cent. UK real estate, emerging market debt and commodities also posted negative returns. This compares with global investment-grade credit, which returned 31.8 per cent.
But over a 10-year time frame all of the asset classes outperformed developed market equities. This, according to Towers Watson, is proof that diversification works. The firm suggests three asset classes: reinsurance, volatility and emerging market wealth.
For example, when an investor buys reinsurance risk they receive a premium for insuring against losses in the event of natural disasters, such as hurricanes or earthquakes, using either catastrophe bonds or insurance-linked warrants. Insurance companies that want to pass on some of their risk pay the premium to the investor. Diversity comes because stock market crashes do not cause hurricanes, and hurricanes do not, in general, cause stock market crashes.
The benefits of a diversified strategy can extend beyond just investment returns. Carl Hess, global head of investment at Towers Watson, says that there are two main benefits. The first is a higher governance approach than a simple bond equity portfolio, and the second is that these strategies don’t rely on active management to any great extent, which can keep performance fees low.
And these new products are getting easier to access. Large insurance companies including Swiss Re and Assurant are big providers of catastrophe bonds. Also, more asset managers are adapting to a new reality where the risks of equity-only strategies are high. For example, Mill Group is soon launching a £500m housing fund for UK investors, which targets the residential housing market in London and the South East.