An act-by-act review of the first quarter

We believe that diversification is one of the few investment principles that no investor should ignore and that gives predictable benefits over time. So how did diversification perform in the first quarter of this year?

Looking at the market’s performance from January to March, we can identify four different acts of the drama:

• Act 1 – on 31 December 2019, China officially informs the World Health Organization (WHO) of pneumonia cases of unknown origin. In the rest of the world, everything is fine. This appears to be a local problem in one Chinese province. We can watch it from a distance, like a movie. It’s scary, but China seems to be getting it under control. It will impact global supply chains and may cause shortages of manufacturing goods for a short while. The rest of the world should be fine, goes the consensus.
• Act 2 – from around 20 February, there is suddenly evidence of the virus spreading outside China. It shows up in many countries within a few days, including South Korea, Japan, and Italy. It’s not a pandemic yet, but it suddenly looks dangerous and disruptive. Equities dive.
• Act 3 – Italy orders a shutdown of Lombardy on 8 March. The idea that developed markets are special and can defeat the virus with contact tracing and “surgical” measures turns out to be wrong. Many more countries go into lockdown over the next few days. Markets are in panic, investors dump all risky assets, market volatility spikes, and “betas go to 1”.
• Act 4 – fiscal and monetary policy steps in. The US agrees a $2 trillion support package. The virus seems defeated in China and, while it still ravages the developed world, a relief rally follows as financial markets anticipate that tough measures will allow developed countries to defeat COVID-19 and that governments and central banks will pick up the bill.

Diversification takes many different shapes, and as multi-asset investors we think of diversification as a guiding principle to help us look at asset-class allocations, regional weights, and currencies (we usually assume that issuer and sector risks are absent anyway).

A very simple approach is to look at three different types of asset class: equities are the most risky parts of a portfolio, and they provide exposure to corporate profits; bonds (governments and investment-grade credit) are the relatively safer assets; and then there are the alternatives, which provide access to various other return streams (property, infrastructure, commodities, high-yield credit, emerging-market debt, etc).

Alternatives are a key feature of a diversified portfolio as they should contribute to expected returns, as well as being expected to perform in a different way from equities over time.

Let’s take a look at the performance of these three building blocks through the crisis:

• Act 1 – positive performance everywhere. In particular, equities, alternatives, and bonds all provide positive returns.
• Act 2 – equities dive, bonds offer some protection, and alternatives are modestly down. Diversified portfolios look stable (with less than half the equity downside, despite the significant selloff).
• Act 3 – this is the pain trade. Market participants sell everything that is risky, everybody wants to hold cash, and even some government bonds become illiquid over a short period. Bonds sell off, and alternatives lose almost as much as equities.
• Act 4 – after the panic, normality returns. Equities rise sharply. Bonds and alternatives recover as well.

Diversification did well in Acts 1 and 2, with a good return in the former and efficient risk management from both bonds and alternatives in the latter as equities sold off.

The big question is what happened in Act 3: diversification didn't help as much during the panic. But it is hard to see what would have helped, as even bonds sold off materially over just a few days so there was nowhere to hide.

Did markets get it right during this period? Usually I am cautious about blaming any market move that we can’t explain on "behavioural biases" and "irrational behaviour". We went through a few days of panic when taking any risk was considered bad. There were some forced sellers, while most investors were reluctant to add risk without being able to analyse the risk they were taking. We are all experts on pandemics now but the outcome of the outbreak looked very uncertain for most of the first quarter and lots of risks still remain. Panic selling while market liquidity is thin and there are no buyers will cause severe market falls similar to those seen in Act 3.

The last time we observed such a panic was during parts of the global financial crisis when investors were confronted with equally unfamiliar events. When looking at these time periods with just a little bit of hindsight, it looks like market participants took a number of poor decisions. But that is an assessment made after the fact.

If diversification didn’t deliver in the panic of Act 3, what is the alternative? Short-term investors, those who need to be able to liquidate in the middle of such a liquidity crunch, can try one of the following risk-management strategies:

(1) Take less risk all the time (yes, that works, but long-term returns will also be lower).

(2) Systematic risk hedging and dynamic strategies or constant proportion portfolio insurance (yes, they will work but will also reduce returns over time).

(3) Market timing (but who can do it successfully and how?).

Long-term investors with a diversified portfolio should be able to look through the short-term noise. If we extend the observation period just a little bit by combining Acts 2 and 3, then the drawdowns are very much in line with our expectations and the diversification helped to moderate risk.

The picture gets better still if you add the relief rally of Act 4, or looking at the full quarter’s performance.

Investing for the long term allows us to look through the short-term liquidity crisis and irrationality that we have seen.

The selloff provided some opportunities for long-term investors, too. For example, we saw the selloff in alternatives as excessive. In particular in real assets the fall in values seemed extreme in light of the underlying physical exposures. We believe that the coronavirus crisis is particularly deep and severe but will end in 12-18 months at the latest with a vaccine becoming available.

Diversification is no panacea, but we still believe it is the winning strategy for long-term investors.