A decade of central bank money printing has already questioned traditional asset allocation ideas and approaches to diversification. The global pandemic has added a new twist to this. We interview T Rowe Price, the asset manager, about its doubts of whether diversification really does the job investors think it does.

Is the time-honored concept of diversification another victim of COVID-19?

At the very least, the pandemic has exposed diversification as “a flawed concept,” according to Sebastien Page, head of global multi-asset for T Rowe Price.

“Diversification almost always fails when we need it the most,” Page said at T Rowe’s annual Global Market Outlook press briefing. “The industry needs to rethink portfolio construction.”

Page is “not against diversification” in general, he insisted in an interview with Family Wealth Report. “If I had one minute to give financial advice, I’d say stay invested and diversify across asset classes.”

But the market sell-off in the spring and the dominant role that politics and the coronavirus continue to play “has reminded investors that diversification rarely works as intended,” said Page, whose new book, Beyond Diversification, has just been published by McGraw Hill.

What is “problematic,” he said, are the choices investors face when they want to diversify. “If you just say ‘diversify,’ that not enough if it’s not clear what the investment choices are.” 

Diversification difficulties
Assets spread across sectors that share similar risks proved to be “very disappointing” during the market sell off, Page said at the press briefing. “Investors did not get the diversification that should have protected them.”

Conversely, while investors do get a lot of diversification when the market is rallying, it “erodes the upside,” he maintained.

Because assets tend to move together, average diversification across different market environments hides extreme outcomes in times of crisis, and masks too much diversification during market rallies, according to Page.

“If you had your head in the freezer and your feet in the oven, the average doesn’t really reflect the blend of extremes,” Page said. “Diversification works differently in different market environments.”

Investor strategies
So how should investors and asset managers be re-thinking diversification?

Long-duration bonds, absolute return investing, hedging strategies, options and active risk management to keep volatility levels in portfolios stable should all be considered, Page said.

And in a zero interest rate environment, clients’ expectations have to be reset, he cautioned. Negligible rates mean that Treasury notes give investors “no compounding effect after inflation.”

As a result, and because the US Federal Reserve bank is unlikely to raise rates for several years, investors will need to allocate more money to stocks. Page estimates that investors will need to allocate around 80 per cent of their portfolio to equities to achieve a nominal 6 per cent return.
 

The case for stocks
“On a relative basis, we believe stocks are less expensive than Treasuries,” he said. “The equity premium is alive and well.”

Stocks are not in a bubble compared with bonds, Page declared. If stocks are valued by discounted future cash flow, it’s logical that the stock will be valued higher if the discount rate goes down.

In addition, the large amounts of liquidity in the markets and cash on the sidelines further indicates that investors “are willing [and] able to buy on dips,” according to Page. “It’s dry powder for the markets.”

As for market trends, T Rowe is “closely monitoring the potential for a great rotation from growth to value stocks,” Page said. “Investors should look to take advantage of cheap cyclicality on a relative basis in small caps, high yield and emerging markets.”