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22 May 2020

David Prosser explains how alternative investment companies can offer diversification to your portfolio.

Diversification is a basic principle of investment – the idea that you protect yourself from market volatility by having a good spread of assets, so that one area provides compensation when another is falling short. But what happens if an apparently diversified portfolio of assets isn’t really diversified at all? One feature of financial markets over the past decade or so has been increasing correlation between the major asset classes, which have tended to move in parallel to a much greater extent than in the past. That heightened correlation has been especially notable during the downturn of the past few months; safe havens during the Covid-19 crisis have been difficult to find.

These are unprecedented times. But they do give pause for thought about some long-accepted investment basics. Diversification is fine in principle, but how do advisers and investors achieve it in practice? In particular, fixed-income assets, traditionally the counterpoint to equity allocations, have fallen in lockstep with share prices in recent months. In other words, they have added to the volatility, rather than providing respite.

What’s needed in this environment is a broader range of investment options. The traditional approach to diversification, with portfolios split between equities, fixed-income, cash and maybe a bit of property, is no longer fit for purpose. To manage risk, we need to look further afield.

But how to do that? Conventional asset classes are wonderfully accessible, but areas such as infrastructure, private equity and other types of alternative assets are typically much more challenging for most advisers and investors. Direct holdings are usually off limits to all but those with the deepest pockets.

Enter the investment companies sector, which has an impressive long-term record of innovation in portfolio diversification, opening up asset classes to a broader range of investors.

In this regard, data just published by Investment Week magazine makes fascinating reading. It charted the growth of assets in a range of different classes held by investment companies over the past 25 years. Equities, as you would expect, have dominated throughout, but the striking element of the data is how new asset classes have emerged in the industry.

Infrastructure funds, for example, barely registered before 2006, but were worth £19.5bn by the end of 2019. Debt funds arrived in 2005 and would grow to £9.35bn by 2019. Private equity and property funds were rare 25 years ago, but are now significant sectors of the investment companies market.

Had Investment Week looked further back in time, it would have found this story constantly repeating itself. From the earliest days of investment companies, back in the second half of the 19th century, funds have constantly evolved, offering access to new types of opportunity.

What we’re looking at here might be described as the democratisation of investment. Via the investment companies structure, even investors with modest means have access to asset classes once regarded as the preserve of institutional investors and those of high net worth.

That might feel like a rather worthy sentiment. But in the context of the dynamics of financial markets today – where traditional asset classes are so highly correlated at a time of elevated risk – it also has huge practical value. Investment companies offer a means through which it is possible to return to that first principle of investment – that diversification offers protection – much more effectively.