Do diversified portfolios still pay off for clients?

It is becoming more difficult for financial advisers to build investment portfolios, according to Morningstar, as broad portfolio diversification has often failed to add value in recent years. 

In its 2024 Diversification Landscape report, the research firm said US stocks bounced back from losses in 2023 but most other asset classes fell behind. This meant a diversified portfolio made up of 11 asset classes would have returned 13.8 per cent over the year compared to 18 per cent by a 60/40 portfolio made up of US stocks and US investment grade bonds. 

Its diversified portfolio included 20 per cent to large-cap US stocks, 10 per cent each to developed market equities, emerging market equities, treasuries, US core bonds, global bonds, high-yield bonds; and 5 per cent to small-cap stocks, commodities, gold and REITs.

The diversified portfolio would have reduced risk, Morningstar said, but not sufficiently enough to result in higher returns. 

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A broadly diversified portfolio had performed better than an all-stock portfolio between May 1993 and December 2016, but since then, they had seen weaker risk-adjusted returns. 

Morningstar said: “While broad portfolio diversification led to slightly lower losses during 2022, this approach has often failed to add value when compared with an equity-only portfolio or a plain vanilla mix of stocks and bonds.

“After decades of relatively low inflation and generally declining interest rates, both measures have shown signs of a fundamental regime change. As a result, the previously ideal conditions for stock/bond correlations are no longer in place, and correlations between stocks and investment-grade bonds have been positive since 2022. That, in turn, reduces the diversification value of bonds from a portfolio perspective.”

However, it was not all bad news as Morningstar pointed out stock and bond correlations may have moved higher but are still low in absolute terms and have rarely increased higher than 0.60.

“Holding a variety of asset classes helps guard against being overly exposed to an area that falls out of favour. Asset classes with lower correlation coefficients can also reduce a portfolio’s risk profile. Finally, holding a diversified portfolio helps investors expand the opportunity set and ensure they do not miss out on areas that can enhance long-term returns, such as international stocks.”

Crypto assets
The report also touched on whether there is a benefit from adding crypto assets to a portfolio for diversification purposes. Crypto is gaining more interest from both retail and institutional investors driven by strong long-term returns, digital innovation and resurgent inflation.

But Morningstar warns it experiences extreme performance swings which can shake clients’ confidence in times of downturns.

“Although current correlation numbers are still quite low compared with those of other major asset classes, cryptocurrency’s low correlation with traditional asset classes may be a bit of a false flag because of its tendency to spike during market corrections.

“It’s also worth noting that cryptocurrency’s volatility profile means that even small doses can have an outsize impact when added to other portfolio holdings. As a result, most investors will want to keep cryptocurrency exposure to a minimum and carve out any allocations from stocks, not bonds.”