Searching for genuinely different sources of return

Diversification is one of the most familiar ideas in investing. In simple terms, it means not relying too heavily on one source of return. A portfolio can look well diversified on the surface, with exposure to many asset classes, regions and sectors, but still be driven by a small number of common forces underneath.

Most multi-asset portfolios are built mainly from equities and bonds. Equity exposure may be spread across thousands of companies, and bond exposure across governments and companies. That matters, but it does not always mean the portfolio is protected from the same big market drivers.

That is why we spend time looking beneath the headline asset allocation. The question is not only whether a portfolio owns lots of different investments, but whether those investments behave differently when markets are under pressure.

One way to explain this is through cooking. Many recipes look very different, but often rely on the same core ingredients. Portfolios can be similar. They may contain a range of funds and asset classes, but the returns can still depend on a few common ingredients.

Our analysis suggests that a large share of returns across many asset classes can be explained by a small number of common factors. These typically include economic growth, inflation, real interest rates, and credit risk. While important drivers of returns, relying on them too heavily can leave portfolios more concentrated than they first appear.

This creates an opportunity to seek diversification from return sources that are less closely linked to these broad market drivers. Often referred to as alternative risk premia, they are persistent market patterns or behaviours that may provide returns over time when accessed in a disciplined and systematic way.

Two opportunities that currently stand out for us are volatility risk premium and cross-asset momentum.

A helpful way to think about the volatility risk premium is through insurance.

Many individuals and businesses are prepared to pay for protection against unforeseen events. Because such events occur relatively infrequently, those providing the protection can, over time, earn more in premiums than they pay out in claims.

A similar dynamic exists in financial markets, where investors often pay to protect their portfolios against sharp markets declines. Those willing to provide that protection can earn a premium over time.

Most of the time, markets experience normal fluctuations rather than severe dislocations. During these periods, the strategy can continue collecting option premiums. Occasionally, sharp market sell-offs can lead to losses as the protection becomes valuable.

However, stress is often accompanied by a significant increase in implied volatility, reflecting a greater demand for protection. This typically results in higher option premiums, improving the potential return available to investors willing to provide that protection. As a result, periods of weakness can help create more attractive opportunities going forward. For the strategy to struggle over the long term, markets would need to experience repeated and severe sell-offs without a meaningful increase in the compensation available for bearing this risk. History suggests that such environments have been uncommon.

For investors, this offers a potential source of returns that is different from simply owning shares or bonds. We believe it can therefore help improve diversification within a broader portfolio.

Selecting the right managers matters. While the underlying idea is straightforward, there are different ways of implementing it in practice.

For volatility, we selected two complementary approaches. Importantly, these strategies are systematic: rather than relying on a manager's views about where markets might go next, they follow a defined set of rules designed to capture the opportunity consistently over time. The two approaches focus on different markets, with one providing targeted exposure to the US equity and the other accessing opportunities across a wider range of developed and emerging equity markets. We believe combining them creates a more balanced allocation, because it avoids relying too heavily on any single market.

Cross-asset momentum, often called trend-following, is built on a simple observation: markets can continue moving in the same direction for longer than many investors expect.

Part of the reason lies in investor behaviour. New information is rarely incorporated into market prices instantly. Instead investors often react at different speeds, with some adjusting their positions more quickly than others. As a result, market moves can persist as information is gradually absorbed and reflected in prices. Behavioural biases, such as herding and investors tendency to extrapolate recent trends, can further reinforce these movements.

Trend-following strategies seek to take advantage of this characteristic. Rather than trying to predict where markets should go, they look at what markets are actually doing and position accordingly. If a market exhibits a sustained upward trend, the strategy can seek to participate in that move. Equally, if a market is trending downwards, it can take a short position and potentially benefit from the decline.

The "cross-asset" element is important. Rather than relying on a single market, these strategies can identify and respond to trends across equities, bonds, currencies and commodities. This broad opportunity set helps diversify sources of return and increases the likelihood of finding attractive trends in different market environments.

For our multi-asset portfolios, momentum helps us respond dynamically to evolving market trends. This can help us participate in rising markets, but its greatest value often emerges during periods of market stress. Because the strategy can benefit from both rising and falling markets, it has historically provided diversification when traditional assets have struggled.

That does not mean it delivers strong returns every year. There can be extended periods when trends are weak, short-lived or frequently reverse direction, resulting in more muted returns. Historically, however, these phases have often been offset by stronger performance during prolonged market dislocations and bear markets, when sustained trends can emerge across asset classes.

A good example was 2022, when both equities and bonds came under pressure as interest rates rose sharply. Strong downward trends developed across many markets, creating an environment where cross-asset momentum was able to provide positive returns and diversification when investors needed it most.

We can’t predict the future.  Past performance isn’t a guide to future performance

As with our volatility allocation, our momentum managers employ systematic, rules-based investment processes. Rather than forecasting economic events or making discretionary market calls, they use quantitative models to identify and respond to trends as they emerge.

For cross-asset momentum, we selected two managers that look to exploit trends at different speeds:

• One reacts more quickly to changing market conditions. This can be beneficial when trends emerge rapidly or when leadership shifts suddenly between asset classes.
• The other responds more gradually to changing market conditions, placing greater emphasis on trends that have become more established. This can help avoid reacting to short-term market noise and temporary market moves.

By combining the two, we gain exposure to both shorter and longer-term trends. We believe this creates a more balanced approach than relying on a single trend-following model.

Portfolio diversification can be more challenging than it first appears. Many asset classes are influenced by the same underlying drivers, which means portfolios can be more concentrated than investors realise. The relationship between equities and bonds has also evolved over time, making it increasingly important to understand what is really driving returns across the whole portfolio.

Alternative risk premia are not a cure-all. There will be periods when they underperform, and not every apparent opportunity will prove persistent. That is why our process focuses on identifying clear return drivers, robust implementation and careful manager selection.

Where we find opportunities that meet those standards, we believe they can play a valuable role within PruFund. By introducing additional sources of return, they can help strengthen diversification and improve portfolio resilience across a range of market environments.

This content has been prepared by the Life Investment Office (LIO) for information purposes only and does not contain or constitute investment advice.