Investment diversification – alternative asset classes that can enhance your portfolio’s diversification

Diversification of investments is one of the most effective ways to balance the risk and reward of your portfolio. The word ‘diversification’ refers to the practice of spreading your money around to ensure you are not overly exposed to any one type of asset or, to put this another way, to avoid putting all your eggs in one basket.

The most traditional example of diversification may be the 60/40 portfolio – referring to a portfolio that would be 60% allocated to company shares (equity) and 40% allocated to government and company bonds (fixed interest). Whilst this is not an investment approach we would endorse at Mattioli Woods, since this is not the approach we take with any of our multi-asset portfolios, this type of portfolio split is often viewed as the typical asset allocation for a traditional portfolio with a ‘balanced’ or ‘medium’ level of risk.

Historically, fixed interest assets have been negatively correlated with equity markets, meaning when the value of one increases, the value of the other would typically decrease. With a portfolio asset allocation as described above, this would allow the value of the portfolio to benefit from equity market growth, while being somewhat protected against extreme volatility (sudden change in value), that may be characteristic of a portfolio that was 100% equity based, for example.

In more recent years, it has been brought into question whether the traditional, almost ‘perfect’ relationship between equities and fixed interest remains what it once was or indeed what it has widely been deemed to be. For example, where we have seen more uncertainty over inflation levels and interest rates, off the back of the short and intense ‘rebound’ in economic growth following the onset of the Coronavirus pandemic, the relationship between equities and fixed interest, has, at times, appeared to be far more positively correlated.  

While modern day fund and portfolio managers have plenty of asset classes at their disposal - such as property, cash, commodities and alternatives - equities and fixed interest remain major players in portfolio construction. The job of a portfolio manager becomes increasingly more challenging as equities and bonds more frequently behave in the same way.

Have you heard about structured products?

Readers will no doubt be all too aware of the current investment landscape we find ourselves in, and with the magnitude of uncertainties surrounding markets, the benefit of lesser-known investments strategies may come into the spotlight.

Structured products are pre-packaged, fixed term investments, which have a return linked to an underlying market or asset. The key term here is linked, because while performance of the product may derive from the performance of a market or asset, it does not mean the return will be the same. In uncertain times structured products can be constructed to pay a potential return if the underlying assets they are linked to fall by a certain amount, stay the same or increase throughout the life of the structured product. Please see the example below.   

They can come in all shapes and sizes, meaning they can have a variety of length of terms, with a variety of defined performance opportunities, linked to a variety of underlying assets.

In short, a structured product’s return will be pre-defined (although not guaranteed) and will depend on the performance of the underlying equities, indices, commodities, currencies, or other alternative measurable indicators, for example the rate of national inflation.

 A basic example of a structured product may look something like the below:

• Maximum term = seven years.
• Underlying assets = A leading UK equity benchmark index and a leading European equity benchmark index.
• Potential return = 8% per annum paid annually from the second anniversary of the start of the structured product.
• Pay out triggers = if both indices are at or above the Coupon Barrier Levels
• Coupon Barrier Levels = if both indices are at or above their initial levels (the closing levels of the indices on the start date of the structured product) on the second anniversary of the start date of the structured product, the structured product matures and returns 16% plus the amount originally invested. If one index is below its initial level, the structured product continues and the Coupon Barrier Level reduces by 5% per annum, observed annually until the Final Maturity Date.
• Barrier to capital loss = if the worst performing index is below 65% of its initial level on the final maturity date, 7 years after the start of the structured product

If any of the pay-out triggers were not met, this structured product would run for a maximum of seven years.

If at the second anniversary date of the structured product both indices were at or above Coupon Barrier Levels, the structured product would pay the investors back 100% of their investment plus 16% (8% per annum for two years). If the structured product did not pay out at year two, the missed 16% would accrue to year three meaning the possible pay out would be 24%, and so on.

If the opportunity to pay out did not occur before the maximum term of the structured product (7 years), the structured product would return 100% of the amount originally invested, providing both indices are at or above 65% of their initial level (this is the barrier to capital loss). If this is not the case, investors capital will be reduced on a one-for-one basis versus the worst performing index. Therefore, if the worst performing index has fallen by 70%, the investor only receives 30% of their initial capital back.

The opportunities

Structured products are issued by global investment banks and are designed by specialists. Typically, the more uncertain or volatile the traditional investment landscape, the more opportunity managers have for creating potential higher returns and/or lower risks in the structured product

As with any investment products, the predefined performance is of course not guaranteed and there will always be a risk of capital loss (you get back less than you invested). An investor’s ability to bear these risks, alongside the suitability of the investment strategy, should always be considered first and foremost.

In a climate where nothing appears certain, and very few professionals seem able to predict the next move in markets, the opportunity to potentially receive a pre-defined return over a fixed term, with transparency over the risk of capital loss, may just be the ticket to finding further portfolio diversification.

At Mattioli Woods, we look to utilise a range of asset classes within our client portfolios. This could be solely via our discretionary portfolio management service - which includes our range of multi-asset funds that invest dynamically across multiple asset classes utilising a ‘fund of funds’ structure for additional diversification - or by pairing this with other assets from our in-house solutions, such as the commercial property real estate investment trust (REIT) or our bespoke structured products.

Considering our clients’ overall objectives and appetite for risk, we typically consider a range of investment strategies that will differ from client to client to ensure it is right for each individual. While lesser-known investment opportunities will of course not be suitable for everybody, it is valuable to have these as part of our tool kit when constructing suitable and appropriate strategies, working towards objectives.

Note that the above examples should not be construed as advice; investment decisions should be guided by formal advice, with consideration of individual circumstances.