Institutional Investors Should Build More Diversified Portfolios

Towers Watson said institutional investors that have diversified their assets away from developed market equities during the past five to ten years will have made the case for diversification as almost every other asset class outperformed these markets during this period. The article, Is diversification dead?, suggests that a diverse portfolio of market opportunities, combined with better techniques to manage liability risks, can improve efficiency by 20% to 40% compared to a simple bond/equity mix.

“This type of portfolio can be made up of beta opportunities and does not necessarily need to rely on active management to any great extent. As such it can be implemented with considerably fewer managers than we would typically use in a fully active portfolio: so eight to 12 rather than 25 to 35 investment managers,” said Carl Hess, global head of investment at Towers Watson, according to a press release.

The firm suggests three new specific diversification opportunities having considered the fundamentals: insurance-type strategies; the emerging market wealth theme; and alternative betas.

Regarding insurance-type strategies it recommends reinsurance, accessed via catastrophe bonds, and other insurance-linked securities. According to Hess: “Insurance strategies are fundamentally unlike the mainstream asset classes of equities, bonds and real estate, which rely to varying degrees on economic growth as the source of return and risk. Insurance strategies instead provide a risk transfer mechanism, for which there should be a premium that investors can take advantage of.”

Towers Watson said many institutional investors still have a very small allocation to emerging markets, for example the emerging market weighting is only around 10% (excluding Taiwan & Korea) in a global equity index. It recommends investors increase allocations to emerging markets, via companies more directly exposed to emerging market growth, in areas such as infrastructure or domestic consumption, rather than on large global companies based in these countries.

In addition, it believes that there is an alternative way of exploiting productivity growth by investing in a range of countries whose economic fundamentals look strong, via a basket of emerging market currencies. Furthermore, with over 70% of the emerging market debt universe now denominated in local currency bonds, emerging markets are now much less exposed to a currency crisis making their debt a more attractive investment.

Towers Watson also believes the use of alternative (or exotic) betas can have a strong diversifying effect on a fund’s portfolio if properly constructed. It suggests there are two main ways to access them: first by applying strategies that exploit asset classes not typically used by most investors, such as reinsurance and volatility strategies as well as emerging market currencies; and second through strategies that exploit systematic risk premia in conventional asset classes, which includes investing in value and small cap stocks, as well as carry and potentially momentum strategies across a range of markets, as well as merger arbitrage and convertible arbitrage.

Global Investment Matters is an annual publication covering topical investment issues and is available at http://www.towerswatson.com/research/1490.