There is no doubt that a robust, well-diversified portfolio can minimise risk and be extremely beneficial for investors in the long term. Unfortunately, however, a number of investors have suffered significant capital losses on the back of having a strategy that appeared to be diversified, but in fact wasn't diversified at all.
The benefits of a robust diversification strategy are more apparent when volatility picks up or when markets start to fall. Once a market advance has persisted for an extended period as we have been experiencing of late, investors tend to become complacent and often can't be blamed for doing so. This can lead to a dismissive attitude towards the benefits of diversification. Volatility, as measured by the VIX Index, is now at the lowest level in over five years. The S&P 500 has recently touched an all-time high while the German DAX and the UK FTSE 100 are close to five-year highs. Even domestically we can see that Kerry Group and Glanbia are at all-time highs with Ryanair just 30 cents away from its high in 2007.
What is diversification?
Traditionally, a portfolio's diversification strategy was considered to fall under two headings: 'asset class' mix and 'geographic' mix. The simple belief has been that by having your funds invested in separate, distinct asset classes such as domestic equities, international equities, government bonds, corporate bonds, commodities or hedge funds across a wide number of geographies, then you were fully diversified so that in the event of, for example, an equity market correction or a large sector decline, the impact on your portfolio should be minimised.
However, there is very little mutual exclusivity when it comes to these asset classes and geographies. In terms of asset class mix, in recent times we have seen a reclassification of certain asset classes relative to other asset classes and we have seen growing disparities within certain asset classes also.
For example, certain individual corporate bonds are not too dissimilar to high- yielding equities and may even pose a higher risk than certain equities. We have seen within the government bond space that there is an enormous disparity within this asset class e.g. core European Government bonds such as Germany (which are priced as being lower risk than cash deposits in certain economies) versus peripheral European Government bonds such as Greece. In relation to equities, for example, there is a major difference in risk between purchasing a single stock in the emerging markets and investing in a passive exchange traded fund (ETF) in a major developed economy such as the FTSE 100 ETF.
Investors shouldn't discount the impact of globalisation
Just because a company is listed on an exchange in a particular country, does not mean that that company derives their earnings from that particular country. For instance, if an investor believes that by buying shares in the US they are getting direct exposure to the US economy, then all they need to do is look at the geographical exposure of some of these large S&P 500 companies such as Apple, Exxon Mobil, Microsoft and IBM. Even in a small market like the ISEQ in Ireland, most of our largest companies such as CRH and Ryanair earn the vast majority of their revenues from outside of Ireland and all of the companies above in general are continuing to expand their geographical focus.
Thinking outside the mix
Basing a diversification strategy solely on the asset class mix and the geography mix can be misleading and is relatively futile. Investors need to look at the constituents that will populate their portfolios in a fundamentally different way.
Here are five useful measures that investors should employ to improve their portfolio's robustness.
1. Diversification in terms of inflation
A well-diversified portfolio will contain assets that will perform well in a deflationary environment, such as long-dated conventional bonds, and assets that will out-perform in an inflationary environment, such as certain commodities and inflation-linked bonds. At this point in time, because of the abundance of quantitative easing by central banks, the risks of inflation over the medium to long term are now very significant so portfolios should be weighted more towards hedging this particular risk as opposed to deflationary risk.
2. Diversification by active versus passive
Many investors believe that they should have their entire equity portfolio in passive investments through ETFs to avoid paying for active management. While it is true that passive ETFs are useful to provide low cost and transparent exposure to certain asset classes or geographies, this passive nature means that they do not react when markets sell off and the performance is completely pegged to the underlying index. Further, there are a number of active funds that have consistently outperformed their benchmark index on an annual basis so investors need to consider the opportunity cost of not having exposure to these funds. There are merits in using ETFs, but from a diversification point of view investors may be better advised to have the appropriate mix between passive ETFs and actively managed individual securities and funds.
3. Diversification by fund manager
Investors would also be well-advised to use a number of different active funds to fill that allocation as opposed to one individual fund. In the absolute return and hedge fund space, for example, the performance is often predominantly down to the skill of the individuals who are running the fund, meaning that investors will be very dependent on the performance of one particular individual's view of markets. Using a number of third party active funds will significantly reduce this risk.
4. Diversification by market timing
When an investor has a lump sum to invest, it should never be done all at once and instead should be phased into the market on a gradual basis to take advantage of opportune times to buy assets and to reduce entry risk. A well-diversified portfolio will only contain liquid assets so that it is in a position to react and benefit from economic newsflow and changes in market prices.
5. Diversification by sector and size
Investors should always be aware of the underlying sectors that their investments are allocated to and they will therefore be able to tell if they are over-reliant on any one particular sector. Shares within particular sectors are often more correlated with each other than shares within the same geography; a good example of this is the big correction in the Technology Sector in 2000 and construction and banking sectors in 2007 / 2008. Furthermore, having a healthy mix between large-cap and medium-cap companies within Equity and Corporate Bond Portfolios is also important.
Investors need to carry out a deeper analysis of their diversification strategy to ensure that they fully understand the level of risk in their portfolios and to mitigate losses in the event of future market downturns.
The content of this article is intended to provide a general guide to the subject matter. Specialist advice should be sought about your specific circumstances.