Unhelpful good times

Flagging asset rally poses diversification dilemma

A general hunt for yield is causing many asset classes to move in a more synchronised way. That's a problem for investors trying to construct a portfolio ready for tougher times.

It's a version of the pattern established after the financial crisis, when investors basically divided assets into two classes: risk-on and risk-off. For years, careful analysis of different securities became almost irrelevant. But then, abundant central bank liquidity and recovering economies helped re-introduce more differentiated movements between and within markets.

More recently, though, a new sort of simplification has taken over: the all-out hunt for higher yield. It's a natural response to the expectation of very poor returns on short-term safe assets, but it has led an array of prices to move in similar fashion. For example, the average of correlations between credit, emerging market government bonds, and top-rated developed government bonds is currently around 0.38, according to Societe Generale. While that is well below the perfect lockstep of one, it is the highest in at least a decade and more than double the levels that prevailed just over a year ago. What's more, developed equities and government bond prices are rising in tandem rather than moving in opposite directions, as is the norm, the French bank points out.

As long as markets go up, going up together is not a headache. However, the pattern is a challenge for an asset manager who thinks equity markets are looking particularly overstretched, or for one who is concerned that bonds may be vulnerable to the prospect of higher US interest rates. Paring equity holdings to buy more bonds - or doing the opposite - doesn't really deliver diversification if the two asset classes are both liable to fall at the same time. Investors could always venture further afield, into alternative assets such as real estate. But the isolation comes at a price. It may not always be easy to dispose of these less liquid holdings at a good price. Picking a portfolio that can weather swings and roundabouts is always challenging. The broad-based asset rally of the past year makes it harder still.