True diversification matters in portfolio construction. ILS one of the best: Natixis

In 2018 when global investors suffered as markets fell and equities in many cases failed to perform, investments in some asset classes that had been promoted as diversifying failed to deliver on their promise, Natixis Investment Managers said.

The decline in global equity markets contributed roughly two-thirds of the losses investors saw in their portfolios during 2018, Natixis said in its latest Global Portfolio Barometer report.

Many investors had hoped that investments in fixed income, multi-asset funds and multi-strategy alternatives would provide a level of diversification to their overall investment portfolio returns, but in 2018 these assets largely failed to mitigate the impact of the equity market decline.

That’s because they weren’t offering the true level of diversification that is required, being weak-linked to the same financial market conditions that drove the equity impacts, Natixis said.

Natixis analysed “moderate-risk” or “balanced” model investment portfolios across seven countries and regions, including France, Germany, Italy, Latin America, Spain, the United Kingdom and the US.

Those with the lowest risk equity allocations in Italy fared best (-3.2% on average), followed by Latin America (-4.4%), UK (-4.2%), France (-4.9%), US (-5.1%), Germany (-5.4%) and Spain (-5.9%).

“Volatility returned in 2018 and portfolio risk levels were substantially higher. At the same time, signs of an end to the long bull market began to materialize,” explained Marina Gross, Executive Vice President of Natixis’ Portfolio Research and Consulting Group. “In a complete reversal of fortune, moderate-risk portfolios that saw double-digit gains aided by overweight allocations to equities in 2017 suffered grave losses due to overexposure to the same asset class in 2018. Moving forward, it is more important now than ever for investors to consider increasing risk-mitigating investments to reduce market exposure.”

Increasing risk-mitigating investments is a call for more diversifying alternatives, which is exactly what insurance-linked securities (ILS) such as catastrophe bonds and collateralized reinsurance can offer investors.

Natixis said that, “Truly diversified portfolios fare better,” explaining that fixed income and many alternative strategies failed to deliver in 2018, a year when non-correlating returns would have been helpful for investors portfolios.

But the investment managers’ research shows that, “diversification still plays an important role in portfolio construction.”

Natixis added that in its analysis of 2018, “The most-diversified portfolios had lower risk and higher returns than the least-diversified portfolios, demonstrating the important contributions that sound diversification provides.”

Natixis said that many of the more diversifying asset classes actually performed well in 2018, but said that, “investors either did not own these strategies at all or did not own enough of them to make a difference in their portfolios. ”

Adding ILS or reinsurance linked assets to a portfolio can be one way to generate a return that is relatively uncorrelated with the broader financial markets, offering a way for investors to seek out positive returns at a time when other areas of their portfolio may be demonstrating their correlation is closer than perhaps thought.

Of course the last two years haven’t exactly seen the ILS market as a whole offer the best performance, but then we’ve had two years of significant catastrophe losses to deal with.

But some ILS funds did come out of 2018 with positive returns, so investments in these would have been particularly beneficial to investors who found the equity market and its knock-on effects elsewhere painful during the year, as well as for those who found that fixed income and alternative diversifiers failed to deliver as well.

Natixis themselves believe that ILS offers one of the most attractive options for investors looking for truly diversifying asset classes.

Speaking to publisher Citywire, Matthew Riley, who heads up research for the Natixis Investment Managers Portfolio Research and Consulting Group said that catastrophe bonds are among the more idiosyncratic investment classes that are most likely to provide investors with a diversification benefit to their portfolios.

Also read:

Diversification drives ILS investor allocations more than returns.

Investor appetite for alternatives rising, diversification hunt continues.

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