This is a sponsored article from Aberdeen Standard Investments.

Aberdeen Standard Investments’ Irene Goh, head of multi-asset and macro investing, Asia Pacific, talks about the need for all investors to be properly diversified, as well as the importance of geographic diversification.

Irene, global economic growth continues to drive company profitability. Is now really the time to change to a diversified portfolio?
The climate for investing has remained unusually favourable over the past few years, propelled by loose monetary and fiscal policies and the absence of inflationary pressures. This has underpinned riskier assets such as equities but also fixed income, notably corporate bonds – leading to a nine-year run-up in prices. But several issues are clouding the outlook for investors, including doubts over the sustainability of growth and profits, geopolitical discord, and US-led trade protectionism, together creating a challenging backdrop. Even though the global monetary policy cycle outside of the US is expected to turn only slowly, the late – cycle US fiscal stimulus increases the risk of overheating, thereby raising medium-term risks to global economic expansion. With quantitative easing drawing to a close, valuations looking stretched, and an end to this economic cycle in sight, we expect traditional sources of return to dry up gradually, making it harder for investors to meet their return targets in future. While we expect the environment to remain positive for selective investment in risk assets over the longer term, we think investors should look to moderate their risk exposures. Diversification is a good way to achieve that, providing some portfolio protection in the event of a slowdown in growth while not sacrificing the return potential of risk assets that continue to outperform.

What do you believe true diversification looks like within a portfolio?
We believe it means constructing portfolios that draw on uncorrelated or negatively correlated assets in order to lower overall risk, while not sacrificing the potential to generate returns. In conventional terms, diversification can mean investing in a number of securities within the same asset class to lower idiosyncratic risk. A multi-asset portfolio takes that a step further by investing across a range of asset classes. True diversification goes beyond simple asset allocation. It involves spreading risk across hidden drivers of return such as growth, inflation, interest rates, liquidity, and volatility. A portfolio comprised of equities and high-yield bonds might appear to be diversified, but scratch below the surface and you’ll find it is heavily exposed to a common risk factor: deteriorating company fundamentals and weakening economic growth. A truly diversified portfolio would not be as heavily exposed to a single macroeconomic risk factor and would hedge against adverse market scenarios.

When constructing a portfolio, how does one determine if it is properly diversified?
In our view, quantitative tools and qualitative assessment are equally important when creating a properly diversified portfolio. One way to do this is by using a quantitative process based on historical analysis of correlations combined with forward-looking insights on return drivers. At the same time, it is important to assess economic forecasts and market views, and study assumptions about trends and mean reversion. But we recognise that correlation can break down in a distressed market — in other words, the diversification effect can disappear exactly at the point when it is needed most. To overcome this, investors can conduct a qualitative assessment and scenario analysis to adjust and finalise portfolio exposures. Investing in assets exposed to alternative risks, such as options, can also help protect against downside risk, while capitalising on volatility can enhance returns. Multi-asset investors can express views more tactically, for example, by overweighting or underweighting an asset class or country. While this may not change long-term views, it offers the flexibility to boost returns amid changing market conditions. We see benefits in an open-architecture approach since no manager can be best-in-class at all things.

Do investors need to be worried about being ‘over-diversified’ with too many different positions in their portfolio?
Over-diversification can be a problem when positions cancel each other out, which significantly lowers expected portfolio return. It often happens when investors use several different managers for the same asset class. Most of the time they’re paying expensive fees for a total exposure that’s no different from market beta. In the same vein, a passive index-tracking portfolio might be fully diversified, but it eliminates any room for alpha generation. Investors need to strike a balance so that a portfolio is properly diversified across different dimensions of risk, yet at the same time has a sufficient level of concentration that it can generate meaningful excess returns on top of market beta. Ultimately, diversification is not just about lowering risk — it is also about improving risk-adjusted return.

How important is geographic diversification? How heavily should Asia figure in a portfolio, for example?
There is a lot of potential in Asia, where we believe expanding populations and rising wealth will drive structural growth in domestic consumption. There are compelling opportunities found when investing in companies that stand to benefit from consumption directly, such as those trading in everyday essentials, or indirectly, such as banks or telecom firms. We recognise that Asia is fundamentally better placed than developed markets from a growth perspective. Governments in the region have worked to strengthen their current accounts and deleverage their economies, and many are making structural reforms and raising spending to drive growth.

By contrast, authorities in advanced economies have spent much of the past decade artificially propping up markets and adding enormously to their debt burdens. This, in our view, will act as a drag on future growth. Worse, their policies have inflated bubbles in asset prices that will likely burst sooner or later.

This isn’t to say that investors shouldn’t allocate to developed markets, however — investment opportunities exist all around the world, but allocations will depend on the investor’s particular mandate. One point to bear in mind is that a place of listing can be misleading. A firm based in Europe can derive much of its income from Asian or emerging markets while benefitting from high standards of governance and transparency in its home market. So it’s hard to give a generic answer about investing in Asia, but we would always recommend being diversified.

This is a sponsored article from Aberdeen Standard Investments.