A brief history of investment thinking

Douglas Adams’ The Hitchhiker’s Guide to the Galaxy famously offers the following description of space: “Space is big. Really big. You just won’t believe how vastly, hugely, mind-bogglingly big it is. I mean, you may think it’s a long way down the road to the chemist’s, but that’s just peanuts to space. Listen...¹

Much the same might be said of the investment universe. Many investors do not fully appreciate quite how enormous it really is. Limited awareness of its true size and variety may not have been a decisive hindrance during the golden age of investing, when a traditional 60/40 portfolio was usually able to perform well, but the consequences could be greater now.

To understand why, it is first useful to reflect on how this sphere has developed over time and how investment thinking has evolved in tandem. Here, too, many investors may not know the full story.

Although a veritable spring chicken when compared to the galaxy – which is believed to have formed around 14 billion years ago – the investment universe has been around for a while. The first bonds can be traced back to approximately 2,400 BCE, when they were paid in grain in ancient Mesopotamia, while the first modern trading of stocks revolved around the Dutch East India Company in Amsterdam in the early 1600s.

More recently, the Dow Jones Industrial Average was launched in 1896, while a formative version of the S&P 500 was established in 1923. As Figure 1 shows, however, it was not until the 1950s that the era of most interest to us ­ finally dawned.

The emergence of Modern Portfolio Theory (MPT), as formulated by Harry Markowitz, provided the spark². In 1952, when it was first published in the Journal of Finance, MPT was not so much at the cutting edge as beyond it. When Markowitz presented his dissertation to his doctoral adviser – none other than Milton Friedman – he was told it was so far outside accepted thinking that it might not even qualify for a PhD in economics.

Markowitz’s model showed how to quantify both the risk and the return of an individual asset or a portfolio of assets. It pioneered the concept of diversification, encapsulated in the idea that the risk in a portfolio should be less than the risk inherent in any one holding.

Multi-asset investment has since gone on to encompass not just diversification within asset classes but diversification between them, as well as innovations such as geographic diversification and diversification beyond equities and bonds. As the golden age of investing fades further into the past, now may be the time to consider some or all of these approaches.

In search of further opportunities

As observed in Beyond 60/40, the first article in this series, the challenges that confront investors today – and those that are likely to confront them in the future – demand a more creative and flexible view of portfolio construction and asset allocation. The investment universe affords opportunities to achieve this both within traditional asset classes and beyond them.

Diversification within traditional asset classes

Many investors cast their net no wider than equities and bonds. What is regularly overlooked is that diversification opportunities exist even within these most conventional of asset classes.

Examples include global smaller companies, which tend to outperform their large-cap counterparts over the long term³; high-yield bonds, which can be riskier than other bonds but have a potential advantage in shorter duration; and emerging market debt. The last of these offers a means of tapping into structural growth in the developing world, which is home to a burgeoning middle class and numerous promising export markets.

Diversification beyond traditional asset classes

If we look beyond equities and bonds, of course, the investment universe really opens up. Non-traditional diversification opportunities include real estate, which has often provided mitigation against the effects of inflation, and hedge funds, which can augment non-correlated returns but require full transparency around processes and objectives.

Commodities are another option. They can be particularly useful in turbulent times, as highlighted by the investment performance of energy resources – oil and natural gas foremost among them – in the wake of the crisis triggered by the invasion of Ukraine. They are sometimes perceived as vulnerable to the transition to a green economy, yet the attractions of many commodities – the metals needed to make batteries for electric vehicles, for instance – are likely to grow in light of this shift.

Crucially, this kind of “bigger picture” thinking can be captured in portfolio construction across multiple risk profiles. Breaking free from an allocation consisting of a single type of equity, a single type of bond and maybe some cash should appeal even to a relatively risk-averse investor, because diversification is, above all, a means of reducing risk – as Markowitz outlined almost 75 years ago.

Figure 2 further underlines the options available both within and beyond traditional asset classes. The sample funds it illustrates comprise seven equity types and four kinds of fixed income, as well as allocations to real estate and global macro themes – and in some ways even this array only scratches the surface.

Ultimately, the investment universe should be treated as a toolkit. The larger a toolkit is, the better equipped it is likely to be in coping with difficult situations. It may not be necessary to use all the tools, but it is good to know they are available.

Beneath the surface

Once a multi-asset portfolio has been constructed, investors need to truly understand what they own. Not least amid the challenges of the post-golden age, one reason for this is that a portfolio may contain hidden biases that could impact performance. Below are some key considerations of which investors should be aware.

Sensitivity to interest rates

There is a proven market phenomenon known as the duration effect. It describes the relationship between rising interest rates, bond duration and falling prices. Basically, the longer the duration, the further a bond’s price is likely to drop if interest rates go up. This explains, for example, why defined benefit pension schemes holding ultra-long-duration assets have suffered in 2022. What qualified as a safe haven in the past might be something rather different now.

ESG-based structural bias

Almost all investments now take account of environmental, social and governance (ESG) considerations, but some portfolios can be structurally skewed as a result. The problem is that many ESG funds exclude particular sectors – say, those that are carbon-intensive – and are therefore overweight in sectors such as technology, which have good ESG scores. Beware a consequent bias towards growth, as growth-focused sectors can be vulnerable to something similar to the duration effect.

Style/factor exposure

Relatedly, interest rates can also influence which investment style – or “factor” – outperforms. Growth was the factor of choice when rates were low, while value came into its own when rates began to rise. Although there is no right or wrong answer per se, investors should be alert to any strong skew a portfolio might have towards a specific style. Remember: factors can play a substantial role in both outperformance and underperformance.

Market-cap positioning

Many investors in equities know only the large-cap end of the market-cap spectrum. This is undoubtedly the case for those investing solely in major indices, which are dominated by the world’s biggest businesses. This lack of diversification can be painful if circumstances should lead many large-cap companies to underperform – as witnessed, for instance, in the technology sector during 2022. Opportunities elsewhere on the spectrum can be attractive, especially for investors with a long-term outlook.

Home bias

Home bias – the tendency to invest the majority of a portfolio in domestic assets – has been called one of the principal puzzles of international macroeconomics . It is a puzzle many investors are still wrestling with today. A 2022 Invesco study centred on the UK, Switzerland, Germany, Italy and the Nordics found domestic assets accounted for 18% of equities, 30% of fixed income and 50% of property holdings. Geographic diversification can help mitigate the risk of regional underperformance.

Sensitivity to the developing world

Emerging markets (EMs) offer opportunities to invest in structural growth, as mentioned earlier, but investors should keep in mind what is sometimes known as the US dollar effect. The US dollar has been shown to be inversely correlated with EM equities, meaning EMs tend to underperform when the dollar is strong – as has been the case of late – and outperform when it is weak. This is why investors should give thought to the magnitude of a portfolio’s sensitivity to the developing world.

The currency effect

Currency can be a powerful driver of returns – or the lack of them. By way of illustration, consider the charts in Figure 3. The weakness of the pound in 2022 has benefited unhedged sterling investors by cushioning the impact of falling equity prices, as demonstrated by the respective declines of sterling-dominated and dollar-denominated investments in the MSCI All Country World Index – but a strong pound could have the opposite effect. The management of a portfolio’s currency exposure is likely to become increasingly important in the years ahead.

Conclusion

In this article we have examined the likely benefits of acknowledging the breadth and depth of the investment universe when constructing a multi-asset portfolio. We have argued that recognising the full scope for enhancing diversification, improving returns and reducing risk is more important now, in an age of silver linings, than it was during the preceding four decades, when relatively simplistic strategies were able to perform well more often than not.

We have presented examples of how diversification can be accomplished within and between traditional and non-traditional asset classes. We have also outlined some key considerations that may help investors better understand what is happening – or what could happen – within their portfolios.

A question that perhaps remains to be answered is precisely how a multi-asset portfolio should be managed. This brings us to the long-running discussion over the respective merits of passive investing and active management. The final article in this series, Passive and active – the case for both, addresses this issue.