When diversification doesn’t work, then what?

For Professional Clients only. Not for distribution to or to be relied upon by Retail Clients.

Diversification is an industry basic.
“Don’t put all your eggs in one
basket” seems sensible advice; the
assumption is that what happens
to one basket is unlikely to be
repeated with the other. However,
if you’re carrying two baskets and
fall downstairs…

Most client portfolios are
described as ‘Balanced’ or
‘Cautious’, featuring relatively
heavy investment in debt issued
by companies and governments,
i.e. bonds. Bonds’ returns carry
more certainty than equities; they
pay investors a fixed amount of
interest and make a fixed capital
repayment at maturity, however
their price fluctuates beforehand.
Consequently, investors focus
on yields, not prices. Equities,
conversely, are not obliged to pay
a dividend and shares are only
worth whatever someone pays for
them. When investors worry about
companies’ earnings and share
prices falling, bonds appear more
attractive. If shares’ yields rise
(because their prices have fallen)
then we expect bond yields to fall
(and their prices to rise).

It is almost axiomatic therefore
that diversification of a portfolio
between equities and bonds
should lower overall risk. This has
been the experience for the last
20 years, with bond yields tending
to move in the same direction as
share prices – both up and down.
The relationship between bond
and equity yields is therefore
generally assumed to be negative.

Today, ultra-low interest rates have
engendered historically low bond
yields. Yet remarkably, share prices
remain high, because the ‘safer’
bond alternative provides so little
reward; even high yield (aka junk)
bonds in the US currently yield less
than inflation. Relative risks are
out of kilter; despite all-time high
relative valuations, equities are
currently perceived to be less risky
given their superior longer-term
returns (and competitive dividend
yields) versus bonds. Yet bonds
continue to dominate DB pension
scheme portfolios, while many
advisers habitually steer investing
clients to perceived lower risk
portfolios, despite bond and equity
returns becoming highly correlated.

This is an accident waiting to
happen. A negative correlation
between share and bond yields
is not the norm. Most notably,
the late 20th Century saw the
two assets positively correlated
for 30 years, when inflation was
a real concern. Bond investors’
greatest fear is inflation. Bond
prices fall because inflation eats
into the value of the future interest
payments; prices fall as yields rise
to compensate, but also because
interest rates generally rise to
keep inflation in check. Under
the relationship described above,
rising bond yields should mean
rising share prices. However, in
inflationary times I should expect
to pay less today for my future
inflation-eroded earnings and
dividend stream.

The post-COVID boom as
economies reopen has caused
production and supply bottlenecks
that are in turn forcing up prices,
in some cases quite steeply. US
inflation rates are now at a 13-year
high, while in the UK CPI is above
the Bank of England target.

Fears of economic overheating
are rising. The world’s major
central banks have been pumping
astonishing amounts into their
respective economies for more
than 12 years. They did this by
buying back billions of dollars
and pounds-worth of bonds every
month, thus ensuring an ‘artificial’
high demand, hence maintaining
low yields (and higher bond
prices). For younger advisers, this
activity is ‘normal’. For those of
us with more than four decades
of asset management experience,
it is an unprecedented central
bank strategy that will sooner or
later have to be unwound, with no
precedent on which to gauge the
potential effects. If the US Federal
Reserve counters the inflationary

trend by turning off their QE taps
and raising interest rates in a bid
to keep inflation under control,
bond prices could fall significantly.
Indeed, the price of the world’s
‘risk-free’ asset, the US 30-year
Treasury Bond, fell 20% in the first
quarter of this year.

Both bond and equity prices
are currently at historically high
valuations; any evidence of a
sustained resurgence of above target
inflation could signal a
significant revaluation of bonds
with an associated dramatic
impact on the ‘classic’ balanced
portfolio, where most retail
investors find themselves invested.

Advisers need to question the
habitual inclusion of high bond

exposure to mitigate portfolio
risk, challenging their providers’
strategies to ensure Cautious
and Balanced fund investors’
forecast outcomes remain valid.
Investors’ long-term interests
are best served by a focus on
well-diversified equity portfolios,
incorporating large and small
companies along with value
and growth styles. This is the
best defence against inflation.
Marlborough’s risk-managed
portfolios carry higher equity
and lower bond exposure than
is typical for their sectors. This
is with the intention of ensuring
that the potential purchasing
power of your clients’ portfolios is
maintained and indeed enhanced.

Risk Warnings
The following is a summary only of some key items in the Prospectus. Investors in Protected Cell Company (PCC) must have the financial expertise and willingness to accept the risks inherent in this investment.
Capital is at risk. These are the author’s views at the time of writing and may be subject to change.
These opinions should not be construed as investment advice. The value and income from investments can go down as well as up and are not guaranteed. An investor may get back significantly less than they invest. Past performance is not a reliable indicator of current or future performance and should not be the sole factor considered when selecting funds. Our fund of funds range invests for the long-term and may not be appropriate for investors who plan to take money out within five years. The funds will be exposed to stock markets. Stock market prices can move irrationally and be affected unpredictably by diverse factors, including political and economic events. The funds have significant exposure to bonds, the prices of which will be impacted by factors including; changes in interest rates, inflation expectations and perceived credit quality. When interest rates rise, bond values generally fall. This risk is generally greater for longer term bonds and for bonds with higher credit quality. The funds invest in other currencies. Changes in exchange rates will therefore affect the value of your investment. The funds may invest a large part of its assets
in other funds for which investment decisions are made independently of the fund. If these investment managers perform poorly, the value of your investment is likely to be adversely affected. Investment in other funds may also lead to duplication of fees and commissions. Shares may not be redeemed otherwise than on any Dealing Day. There will not be any secondary market in the shares of the Company.

Regulatory Information
This material is for distribution to professional clients only and should not be distributed to or relied upon by any other persons. The Cells referred to are a cell of Marlborough International Fund PCC Limited (the ‘Company’), a protected cell company incorporated in Guernsey and authorised as a Class B Collective Investment Scheme under the terms of the Protection of Investors (Bailiwick of Guernsey) law, 1987, as amended. Investment may only be made on the basis of the current Prospectus, this can be found on the website www.marlboroughinternational.gg. Marlborough International Management Limited is incorporated in Guernsey. Registration No. 27895. Regulated by the Guernsey Financial Services Commission. Licensed under The Protection of Investors (Bailiwick of Guernsey) Law 1987. Guernsey Office: Town Mills South, La Rue du Pre, St Peter Port, Guernsey GY1 3HZ. Tel: +44(0)1204 589336.