With many income investors overexposed to equities, we round up a range of ways to diversify your portfolio.
There has been a marked decline in investor bullishness over the past few months. The US market roared ahead, but global indices from Europe to Asia Pacific have stumbled. Growth has been slower and economic indicators across continents have been disappointing.
At the same time, the world economy has faced new headwinds as the US and China wage trade war. Moreover, central banks around the world (aside from Europe) raised interest rates – and more tightening is on the horizon – a telltale sign of the end of a market cycle.
The whole trend culminated in October’s global market correction. It’s not clear whether this is the end of the bull run, but many investors have been tweaking their portfolios in anticipation of more volatility to come. Robin Geffen, chief executive and founder of Neptune Investment Management, says: ‘As the bull market matures, people start scrambling around to diversify their way out of it.’
What does this mean for income investors in particular? Investors looking to both preserve their capital and maintain stable and secure income should be thinking about diversifying.
Ed Keon, chief investment strategist at QMA, says ‘diversification is important for all investors’, but especially important late in a cycle when market drawdowns are expected imminently.
The need for diversification is made more acute by the likelihood that many income investors, thanks to the historically long bull market, are overexposed to equities. Ed Park, investment director at wealth manager Brooks Macdonald, says: ‘Over the past few years of the bull market, a portfolio focused on global equities has typically performed very strongly, and attempts at diversification have tended to hold back returns rather than maximise client outcomes.’
Bonds won’t do
The traditional way to protect against a downturn is through investing in government bonds, which have historically gained value when equity markets have stumbled and economies weakened. That, however, is no longer an adequate form of diversification, for a number of reasons.
‘Central banks have intervened extensively in government bond markets over the past 10 years,’ explains Alex Shingler, a portfolio manager in BlackRock’s multi-asset strategies income team. ‘As a result, bond prices are potentially distorted in a way that makes them less useful diversifiers in the next market downturn.’ They tend to move more in sync with equity prices.
Investors also have to contend with the fact that we are returning to a more inflationary world, following decades of low inflation, says James Dowey, chief economist and investment officer at Neptune. This means the historical negative correlation between stocks and bonds no longer applies, again making bonds less useful as a diversifier. What’s more, following a decade of ultralow interest rates, central banks are raising rates, which also hurts returns from bonds. Thus, argues Shingler: ‘Income investors today need to look beyond government bonds.’
Look for yield elsewhere
However, while there has been an explosion of interest in so-called alternative assets – investment options that are not equities or bonds – each appears to come with downsides as well as upsides for income investors.
David Thomson, chief investment officer at VWM Wealth Planning, suggests income investors consider property. This asset ‘generally provides a good income and is normally a relatively stable investment’, he says.
But investors should be cautious of the risks associated with property when markets start to tumble. John Husselbee, head of multi-asset at Lionstrust, says: ‘The diversification benefits of direct property and a different source of yield are attractions, but these attractions have been diluted and undermined by the want of daily dealing.’
This has presented problems for property focused open-ended funds, which struggle to offload their assets to give investors pulling out of funds their money back (as property cannot be sold quickly and may have to be sold very cheaply). This can result in trading being suspended, as happened after the 2016 Brexit referendum.
Funds have taken steps to address this liquidity problem, by including more cash or property-focused securities in their portfolios, for example. Husselbee says: ‘Perhaps the closed-ended market [investment trusts or Reits] provides the answer. A trust’s premium/discount mechanism [which forces its share price down, avoiding the need for managers to sell assets] deals adequately with the challenges of daily liquidity, particularly in larger investment trusts.’
However, not everyone is positive about property as a diversifier. Geffen says property may be the worst option. He warns that for most people nearing or in retirement, property – in the shape of their home – is already their largest asset.
Peer-to-peer lending has grown in popularity recently and will be familiar to many income investors. Investors can access the market online through P2P platforms. What’s more, they can invest in P2P opportunities tax-efficiently through the innovative finance Isa (IFIsa). This, however, presents some risk. Investors could lose their capital should a borrower default, as loans are not covered by the Financial Services Compensation Scheme.
An alternative way to invest in P2P lending is through dedicated investment trusts such as P2P Global Investments. However, many financial professionals urge caution. Geffen says: ‘It is hard to see P2P lending escaping higher default rates [among borrowers] as interest rates continue to rise.’ Thomson also urges investors to be wary ‘and limit their exposure to a relatively modest portion of their overall portfolio’.