The power of diversification: Exploring multi-asset funds for balanced portfolios

The power of diversification: Exploring multi-asset funds for balanced portfolios

Diversification through multi-asset funds is an important strategy for investors seeking to balance risk and returns. Holding a variety of assets that perform independently smooths out portfolio volatility over time. Explore the benefits of multi-asset diversification and how it can enhance investment outcomes. Learn key concepts like correlation and examine the historical performance of diversified portfolios while understanding how multi-asset funds provide an effective way for investors to gain risk reduction and return enhancement associated with a globally diversified approach.

1.1 Defining diversification in investment

Investing across a variety of financial instruments, industries, and other categories helps to reduce risk through a process known as diversification. Investing in various areas that would yield higher and longer-term returns is the goal of this technique, which aims to maximise returns.

1.2 Significance of diversified portfolios

Holding a diversified portfolio is important because it helps minimize losses during periods when certain asset classes are underperforming. No single asset class consistently outperforms over long periods of time. Market conditions and economic cycles impact different assets differently. By spreading investments over various asset classes like stocks, bonds, property and commodities, investors can smooth overall returns from their portfolio. Diversification is a core principle of prudent investment management as it provides protection against significant losses from a sector or single security-specific events.

1.3 Introducing multi-asset funds as a diversification tool

Multi-asset funds provide an easy way for investors to build a diversified portfolio. Rather than investing in individual assets across different classes, investors can achieve diversification through a single multi-asset mutual fund or exchange traded fund (ETF). These funds invest in a blend of assets ranging from shares, bonds, property and commodities. The mix is continually adjusted depending on prevailing market conditions. Multi-asset funds offer investors the benefits of diversification through a single investment solution managed by professional fund managers.

2. Understanding multi-asset funds

2.1 Definition and structure of multi-asset funds

Multi-asset funds, also referred to as balanced funds, are investment vehicles that allocate capital across different asset classes within a single portfolio. Their holdings typically include a mix of shares, bonds, property, commodities and cash/money market instruments. Fund managers determine the proportion invested in each asset based on their views on relative market valuation and expected returns. Some multi-asset funds focus on a particular geographic region or market sector while others take a global investment approach. 

2.2 Components of multi-asset portfolios

Common elements that make up multi-asset portfolios include domestic and international shares, government and corporate bonds, commercial and residential property, commodities, fixed income securities and cash equivalents. Shares usually account for 40%-60% of assets with bonds making up 30%-50% and the remaining proportion allocated to alternatives. Actual exposure varies across funds depending on their risk-return objectives. 

2.3 Advantages of multi-asset funds in diversification

Multi-asset funds provide instant portfolio diversification to investors by blending different assets into a single investment. This diversification is more comprehensive than can be achieved by most individual investors. It also spares investors the time and effort required to build and manage diversified holdings on their own. By delegating asset allocation decisions to experienced fund managers, multi-asset funds offer a simple, low-cost way to benefit from diversification.

3. The concept of diversification 

3.1 Benefits of spreading risk across asset classes

Spreading investments across distinct asset classes is important because it reduces the impact of losses from any one class. While shares provide higher returns over the long run, their prices can also experience sharp downswings. Bonds are less volatile than shares but offer lower returns. Property and commodities behave differently from financial assets. By including a variety of assets that do not move in tandem, diversification helps stabilize portfolio value. When some assets are declining, others may be rising in value, offsetting overall losses.

3.2 Correlation and its role in portfolio diversification

The extent to which a diversified portfolio can mitigate risk depends on the correlation between its constituent assets. Correlation measures how two assets move in relation to each other. Low or negative correlation means their prices change independently, providing best diversification benefits. Historically, shares, bonds, property and commodities have exhibited low correlation, acting as effective diversifiers when included together in a portfolio. However, correlation tends to rise during periods of market stress when most assets decline simultaneously.

3.3 Historical performance of diversified portfolios vs. single-asset investments  

Back-tested data shows that diversified multi-asset portfolios have provided higher risk-adjusted returns than single-asset holdings over long time frames. They experience lower volatility while still capturing a reasonable portion of upswings. This is because gains in some assets compensated for losses in others. For example, during the 2008 global financial crisis, most assets fell but bonds held up better than shares, softening the impact on balanced portfolios. Diversification has thus been demonstrated to enhance risk-adjusted returns through lessening portfolio drawdowns.

4. Benefits of multi-asset diversification

4.1 Risk mitigation and volatility reduction

By spreading investments widely, diversified multi-asset funds are better able to control risks than specialized funds focused on single markets or asset types. Risk arises from lack of diversification rather than from ownership of particular assets. Empirical evidence shows multi-asset funds experience lower volatility compared to specialized equity or bond funds due to gains in some components offsetting losses elsewhere. This risk moderation can provide some relief to investors.

4.2 Smoothing investment returns over time

Diversification helps deliver more consistent returns from a portfolio compared to reliance on one asset class. Gains are spread more evenly as offsetting movements across different assets cause lows to be higher and highs to be lower. Over long periods, blended multi-asset portfolios tend to capture the upside of rising markets while limiting downside during corrections. Their returns exhibit less unpredictability, creating a smoother investment experience for investors.

4.3 Capital preservation in turbulent market conditions   

Diversification is most valuable during severe market selloffs, acting as a ballast. It prevents large losses that could jeopardize an investment plan. During past crises like the global financial crisis, real estate crash or dot-com bust, balanced multi-asset funds held up better than specialized offerings due to diversification effects. Losses were contained and recovery was faster as some components gained while others lagged. Preserving capital in such periods of high volatility is crucial for long-term wealth creation through compounding returns.

5. Conclusion

Diversification across various asset classes through multi-asset funds provides significant benefits to investors seeking to reduce risk and enhance returns. When included as part of balanced, long-term investment portfolios, these benefits accumulate over time. While no strategy can offer guaranteed upside or downside protection, diversification has proved an effective strategy historically for mitigating unwarranted risks and achieving more stable, risk-adjusted returns in all market environments. For most investors, multi-asset funds provide a convenient, low-cost route to capture the advantages of a globally diversified portfolio through a single investment.

Disclaimer: This article is published in association with Nippon India Mutual Fund and not created by TNM Editorial.

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