The best way to diversify your portfolio

Professional investor Alistair Evans tips an exchange-traded fund as one of the best ways to spread your investment risk.

Each week, a professional investor tells MoneyWeek where he'd put his money now. This week:Alistair Evans, partner, The Symphony Fund.

When it comes to investment, we've all heard the adage "don't put all your eggs in one basket". Harry Markowitz, a pioneer in the field of applying mathematics to the diversification puzzle, might well be disappointed to see one of the great mathematical breakthroughs of the 20th century distilled down to such a simple analogy. Having all your money in a single investment is by no means sensible.

However, diversification is about more than simply spreading your money across various 'asset classes'. If naive diversification is the aim that is, your goal is to lower the variance of the portfolio return (its volatility) then this would probably meet that need. But in our view, this is more akin to gambling than investing.

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Markowitz's great breakthrough was in fact to discover the mathematical basis for combining uncorrelated assets so as to reduce portfolio risk, without sacrificing return. As Ray Dalio of huge hedge fund Bridgewater once explained: "If you get 15 uncorrelated return streams, you'll improve your return to your risk by a factor of five. That means five times the return for the same amount of risk." The key here is the word "uncorrelated".

When fund managers build portfolios, anything that displays a correlation of 40% or more (ie, the assets move together for 40% or more of the time) is usually seen as statistically correlated. Anything under 40% is considered uncorrelated.

Equities and bonds, which form the basis of a portfolio for most investors, are statistically uncorrelated in the long term, hence the typical 60/40 basic split between the two. They are, however, just two return streams. Moreover, they can become highly correlated in periods of market stress which is precisely when diversification is most necessary! Added to this, a 60% weighting to equities means that more than 80% of the portfolio's risk lies in the stockmarket, which automatically renders your portfolio overwhelmingly 'long the economy', whether you like it or not.

What if there were a better way, one thatcould avoid the common event risk that so many portfolios suffered from in 2008 and maywell suffer from in the near future?We believe that diversifying by 'return drivers', rather than asset classes, is the way to achieve true diversification. This is a term popularised by Michael Dever of Brandywine Asset Management. It refers to the primary underlying condition that drives the price of a market. Over the past decade or so, academics have discovered numerous 'return drivers', including those based on dividends, volatility, illiquidity and cash flow.

Fund marketers have launched hundreds of 'smart beta'mutual funds and exchange-traded funds (ETFs), such as Vanguard's VIG, which focuses on dividend growth, and PRF, which looks for stocks of companies with strong fundamentals. These aim to capture profits by exploiting these 'return drivers'.

Dozens of such drivers can be identified across numerous markets, including commodities, stock indices, bonds and currencies. The Frankfurt-listed Global Growth (ISIN: AT0000A19PD7) exchange-traded instrument is a good example of a basket of uncorrelated strategies with broad diversification of markets traded.

Once you have identified a number of return drivers that are likely to persist in the future, you can design strategies to extract the returns. Combining these strategies can then produce returns that are not tied to global economic prosperity nor the overall economy, therefore delivering the uncorrelated returns investors really need. This is the fundamental basis of a truly diversified portfolio.

Alistair Evans is a partner of the The Symphony Fund.