Years ago, diversifying a large portfolio meant investing in 65 different companies in the country that you lived and worked in, rather than only 30. Fortunately for wealthy families today, spreading investment risk across more than one geography has become a lot easier.
But wealth managers, private banks and family offices say that even more needs to be done — with other assets — to ensure that global families are not still too exposed to local risks.
Diversification, in simple terms, means spreading assets across sectors and countries to reduce the overall impact of adverse price movements in any one of them. Without it, families are, in effect, betting that wherever they live or work will always produce the best investment returns in the world.
Even if that is the case for a short period, it will be a risky strategy for long-term investing. “For the vast majority of people, diversification is a good thing,” explains Ben Seager-Scott, head of multi-asset funds at Evelyn Partners.
However, he and others warn that there is no one-size-fits-all approach to diversification. As James Holder, head of Europe at Citi Private Bank, points out: “Everybody is different, this is not a homogenous marketplace.”
A wealth manager’s diversification strategy must, therefore, take in a full picture of a family’s life and priorities. This will include assets, liabilities, sources of earnings and revenue, places of spending, and tax jurisdictions.
A similar, predictive exercise must be carried out for children or dependants: where they will live, what currency their inheritance will be in, and what their local tax system will be. It must factor in whether there are any plans to live somewhere else in the future — so that the adviser, for example, can start building up assets in that place earlier, to lessen the impact of currency moves.
For clients with a business based in one, or multiple, jurisdictions, it is especially important to look at where the company’s revenue is coming from, says Edward Park, chief investment officer at Brooks Macdonald.
Once this geographical information has been gathered, private banks, wealth managers and family offices will typically start to build a portfolio of equities and bonds drawn from a global weighted index, in which countries are divvied up based on their relative total market capitalisation.
Some business owners may still wish to use their own experience to invest in their local market, says Holder. “There may be circumstances where, because of the success of that business, because of the family’s experience of operating within a geographic environment, their network and connections, there may be very good reasons that they have such a competitive advantage,” he acknowledges.
But, for others — especially owners whose businesses are in developing nations — the investment portfolio should be diversified almost entirely away from their home country.
A similar approach must be taken with business sectors, advisers suggest. “When a family has a substantial portion of their wealth in a cyclical industry — be that something like mining — we want to be quite careful that we focus their investments in a broad range of other sectors which are not aligned with that,” explains John Veale, deputy head of investments at multi-family office Stonehage Fleming.
However, some sectors should be treated differently, he adds. For example, if a client runs a tech firm, that cannot rule out all other tech investments. “You [should] be thoughtful about what is done there as it would have been a very bad idea in the past few years to say, ‘I have got a tech company, therefore I am not investing in [tech companies]’,” Veale points out.
Currency is a further diversification factor, but rarely straightforward. Most wealth managers will not hedge any equity holdings, believing that equities move inversely to the currency in which they are priced. But, for fixed income securities, Park says, there are a number of academic studies showing currency fluctuations have more impact on performance than duration and yield.
For wealth managers, then, the overall objective must be to “prevent currency from being the dominant element [in a portfolio],” says Samy Chaar, chief economist at Lombard Odier.
In practice, however, diversification will not always deliver the highest returns, as it is not intended to do that.
For example, diversified US-based or Swiss-based investors will have missed out on all of the huge outperformance of their home markets compared with international peers.
This can lead to clients wondering if they should focus more on their home markets. But Chaar warns against it, saying that it can lead some to chase returns and mistime the market. “If you do so, it would be like selling at the trough,” rather than the peak, he suggests.
Once assets are invested, a wealth manager will continually review the portfolio, and its degree of diversification. “It is a very live process that never really ends,” says Holder.
Even if nothing has changed from a client’s perspective, there may be a fundamental change to make in the portfolio — for example, in the past year, there has been a move towards fixed income products, which are producing real, above-inflation, returns for the first time in a decade. Also, the past few years have also been abnormal in terms of market stressors, so investors might be forgiven for wondering if it is almost too difficult to diversify them away.
“[Markets have been] hit by a series of very rare external shocks, the pandemic and war in Ukraine . . . it has been pretty intense,” admits Chaar. “You do not [normally] have to deal with these every five years.”