Is your portfolio really diversified?

While diversification is widely seen as key to managing risk, the conventional approach may be too simplistic. Without proper care, it’s easy to fall victim to asset duplication, sector concentration, and overexposure to highly correlated investments. Any of these pitfalls can result in lower risk-adjusted returns.

But what does ‘optimal’ diversification really look like? In today’s uncertain global environment, building a resilient portfolio may require more than just adding a few extra asset classes. It can also be about targeting market ‘factors’ – like value, momentum, and quality – that can help to drive returns, while reducing exposure to those that may hinder them.

What does ‘optimal’ diversification look like?

Portfolio-level diversification

The basics of diversification are simply about spreading investments across assets with low correlation to reduce risk. However, for more sophisticated investors, it’s not just about risk management, it’s about strategically allocating capital with the aim of optimising risk-adjusted returns. The key is understanding how asset classes, sectors, and geographical exposures interact in different market conditions.

Equity vs. defensive allocation

Balancing growth assets like equities with defensive assets such as bonds or cash is central to building a resilient portfolio. However, the ideal allocation isn’t static; it can shift based on factors like risk tolerance, investment horizon, and market conditions.

Younger investors typically lean more heavily into equities, while older or conservative investors may prefer a higher weighting toward defensive assets to preserve capital and reduce volatility.

Diversifying within defensive assets for stability

It’s crucial to go beyond a simple split between growth and defensive assets by considering the specific roles each asset plays. Government bonds, corporate bonds, and cash all offer different risk-return profiles.

For example, during economic uncertainty, high-quality government bonds may provide greater stability, while shorter-duration bonds may perform better in a rising interest rate environment. Investors can tailor their defensive allocation to reflect both market conditions and personal objectives.

Expanding equity exposure beyond domestic markets

On the equity side, diversification across sectors and regions is essential for capturing global opportunities while managing risk. The Australian market is highly concentrated in financials and resources, which exposes investors to specific domestic risks.

Adding international equities helps balance this by providing exposure to underrepresented sectors, like technology and healthcare. Expanding globally can offer more comprehensive diversification and reduce reliance on local market trends.

Leveraging factors to enhance equity diversification

For more experienced investors, ‘smart beta’ strategies that focus on factors such as value, momentum, and quality can help fine-tune equity diversification. By blending these factors, investors can target specific characteristics that have historically delivered strong returns (of course remembering that past performance isn’t necessarily indicative of future returns).

Intra-asset class diversification

Equities: Blending value, momentum, and quality factors

Within equities, diversification goes beyond simply holding stocks across different sectors. Smart beta investing allows investors to target specific drivers that could drive performance, such as quality, momentum and value.

Investors seeking high-quality companies with ‘quality’ metrics of high return on equity, low leverage and relative earnings stability can consider AQLT Australian Quality ETF  and QLTY Global Quality Leaders ETF .

Blending these different factors within an equity portfolio allows investors to potentially benefit in a broader range of market conditions, while avoiding overexposure to any single style or theme.

Strategies such as those implemented in QOZ FTSE RAFI Australia 200 ETF  weight the holdings in the portfolio based on their fundamental size, rather than market capitalisation. By removing the link between the price of a stock and its weight in the index, QOZ’s strategy is expected to be less affected by fads and bubbles.

On the other hand, momentum investing seeks to identify stocks that show a recent trend of outperforming the broad market, based on the theory that such trends are likely to persist, an approach which is supported by economic theory and empirical data. MTUM Australian Momentum ETF  provides exposure to a portfolio of Australian companies with above average momentum scores, as measured by risk-adjusted returns.

Fixed income: Balancing credit quality and duration

Diversification within fixed income is equally crucial. Bonds are not a monolithic asset class, and different types of bonds react differently to changes in interest rates, economic growth, and credit markets.

High-quality bonds, such as those found in AGVT Australian Government Bond ETF  can provide stability, especially during periods of economic uncertainty, as they are less likely to default and tend to perform well during periods of significant equity market weakness.

On the other hand, corporate bonds with lower investment grade credit quality, like those in CRED Australian Investment Grade Corporate Bond ETF , can offer higher yields. While they carry more risk than government bonds, Australian corporate bonds historically have tended to rise when Australian shares have fallen, providing potential diversification and defensive benefits for portfolios.

Duration also plays a critical role in bond diversification. Long-duration bonds, like those in GGOV U.S. Treasury Bond 20+ Year ETF – Currency Hedged , have historically been among the better-performing assets during US recessions and periods of global economic weakness.

Conversely, Australian bank senior floating rate bonds, such as those held in QPON Australian Bank Senior Floating Rate Bond ETF , historically have had a high level of capital stability, and limited capital variability in equity market declines.

By blending bonds with varying credit quality and duration, investors can mitigate specific risks within fixed income, aligning their portfolios with broader economic trends and interest rate cycles.

Commodities: Adding diversification and inflation protection

Commodities can serve as an important diversifier within a portfolio, offering protection against inflation and geopolitical risks.

Precious metals like gold are often viewed as a ‘hedge’ against currency devaluation and market volatility. QAU Gold Bullion ETF – Currency Hedged , which tracks the price of gold, hedged for currency movements in the AUD/USD exchange rate (before fees and expenses), may provide a relatively stable store of value during times of market stress or inflationary periods.

For broader exposure to precious metals and mining stocks, MNRS Global Gold Miners Currency Hedged ETF  offers access to global companies (ex-Australia) involved in the mining of gold and other minerals, adding a layer of diversification through equity investments in commodities.

OOO Crude Oil Index Currency Hedged Complex ETF provides exposure to of crude oil futures, hedged for currency movements in the AUD/USD exchange rate. Historically, oil has had low correlation with the performance of other major asset classes.

Incorporating commodities like oil, gold, and mining stocks can help investors hedge against inflationary pressures and market turbulence, helping to provide additional ‘balance’ within a diversified portfolio.

Conclusion

Diversification is essential to managing risk, but effective diversification requires more than just spreading investments across different asset classes. By targeting specific ‘factors’ like value, momentum, and quality within equities, and balancing bonds by credit quality and duration, investors can seek to optimise their portfolios for both growth and stability. Adding commodities like oil and gold can provide further diversification for different market conditions.

Experienced investors should focus on asset allocation that aligns with both their risk tolerance and market conditions, using smart diversification to capture opportunities and manage risks effectively.