Why investors should consider a differentiated approach in the current multi-asset correlation crunch

Asbjørn Trolle Hansen, Head of Multi Assets at Nordea Asset Management

If traditional asset class diversification has reached its limits, investors can look to adopt differentiated approaches to balancing risk – such as the opportunities available in alternative risk premia.

Investors have experienced several periods of severe market turbulence since the global financial crisis – most notably the European sovereign wealth crisis, the ‘taper tantrum’, and the initial stages of the Covid-19 pandemic. Fortunately, the sharp drawdowns experienced proved on each occasion to be temporary, and the bull run for stocks and bonds ultimately resumed.

With numerous asset classes performing positively in unison since 2009, most multi-asset approaches – including the traditional 60/40 portfolio – largely delivered on long-term investor return objectives. In addition, due to the largely sanguine environment during the 2010s, portfolio diversification – which is perhaps the primary attribute of a multi-asset solution – was only infrequently put to the test.

However, as turmoil swept through markets last year – sparked by aggressive central bank action to tame inflation – traditional diversification methods were regrettably found wanting. Historically, fixed income has been the investor instrument of choice to mitigate equity market downside. But many investors were left with nowhere to turn when both stocks and bonds sold off aggressively in tandem during most of 2022. By the end of the year, bonds had suffered the worst year in history, while most major equity markets remained firmly in the red.

In our view, traditional diversification has for some time not been able to protect investors to the extent it used to. The ‘correlation perfect storm’ we witnessed last year was a painful reminder of this.

The limits of traditional diversification and how investors can react

We are looking into factors like value, quality and momentum as well as other diversifying factors – just to mention a few – with the overall goal to keep a high level of diversification while still being able to profit from market trends and market inefficiencies. We are applying a fundamental and forward-looking approach to assess the attractiveness of different risk premia in terms of their risk/return profile as well as the correlation benefits they can deliver within the overall portfolio context since we believe that value added can be created depending on how you analyse and select uncorrelated risk premia within the overall portfolio. For example, as an alternative to traditional government bonds in recent years, we have utilised areas such as currency-related risk premia. Attractively valued currencies can provide pleasantly defensive characteristics – the simplest example being the Japanese yen versus the euro.

Therefore, we believe investors can capitalise on both cyclical as well as anti-cyclical return drivers from a broad and diversified set of around 30 different risk premia which are spread across multiple strategy types and asset classes. It is important to note that for us diversification is not simply about piling into numerous asset classes, but rather identifying and balancing a select number of robustly uncorrelated return drivers being able to complement each other and deliver added value for investors through most market environments. While risk assets have enjoyed a strong start to 2023, bouts of heightened turbulence are likely to become a feature of the market environment for the foreseeable future, as central banks continue to hike rates in an attempt to cool inflation and the damaging war in Ukraine rages on.

This is why not only a robust risk management being at the beginning of the investment allocation process but also a high focus on liquidity are of paramount importance to us. In our view, risk premia coming only from the traditional investment space will be insufficient to master the increasingly complex market environment and investors need to have an increased focus on alternative risk premia being able to diversify investors’ portfolios without sacrificing returns.

As stability is set to return to the spotlight, we are particularly optimistic on our Stable/Low Risk Equities component, which have demonstrated an ability to perform through periods of heightened volatility – as well as periods of elevated inflation. Stable, high quality and attractively valued companies are naturally in a far better position to navigate through this continually challenging economic backdrop. In addition, we look for companies exhibiting pricing power, which have the ability to pass on inflation price increases. In our view, this is not only a valuable characteristic in the current environment but also an incredibly attractive building block for portfolios in the months and years to come.