10 MODEL PORTFOLIO CONSTRUCTION
MAY 2012 Making the most of diversification
While everyone accepts the principles of diversification, not everyone understands that by studying how funds interact with each other investors can further diversify and lower the overall risk of the portfolio, reaping stronger risk-adjusted returns.
ROB GLEESON Head of Research, FE
Modern Portfolio Theory has been a cornerstone of our industry ever since Harry Markowitz published his Nobel Prize winning work in the 1950s. However, its core principle of “portfolio diversification” is still poorly understood.
The idea that a collection of investments that display high levels of risk individually can be low risk overall is intuitively a difficult notion to understand.
While most people begrudgingly accept this concept at the highest level when considering asset alloca- tion, they revert to an individualist view when choosing funds. This is depriving investors of the full bene- fits of diversification that were iden- tified more than 60 years ago. Diversification harnesses the dif- ferences between investments and offsets their individual fluctuations against each other to smooth out the effect felt by the investor. For this approach to produce a noticeable impact, it is necessary to combine investments with as low a correlation to each other as possible.
Consider two possible invest- ments; one in the UK stockmarket, represented by the FTSE All Share index, and one in UK government bonds, represented by the FTSE Actu- aries UK Government All Stocks index.
ACTIVE VS PASSIVE
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Tracker fund strategy TR in GB Active fund strategy 01/07/08 TR in GB
Individually one is considered high-risk, high-reward and one is considered low-risk, low-reward. By combining these two investments it is possible to receive the returns from both but for much less risk. This can be seen in the chart; although there has been little benefit of investing in equities over the past 15 years, the time period selected demonstrates the concept quite accu- rately.
The approach is understood at the asset allocation level. Asset classes such as equities, bonds, property and cash are chosen for the low correla- tion to each other.
For a desired level of risk, differ- ent mixes of these asset classes are selected to offer the best possible expected returns. This is where diversification usually ends. Many advisers implement their strategic asset allocation by picking funds for each asset class. When assessing suitable funds for their portfolio, they usually look at them in isolation.
Factors such as performance, volatility, the quality of the team, the track record of the manager are the mainstays.
Even professional analysts who strive to delve deeper into the viabil- ity of a strategy, or fund ratings are still treating funds as separate enti- ties and ignoring their interaction with each other.
This is fine for identifying good funds, which is obviously an impor- tant part of portfolio construction, but does not guarantee the best port- folio. Even once you have narrowed down your choices to the best funds
HOW DIVERSIFICATION WORKS
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in each asset class, you are still faced with a choice of at least 100 funds and, for a 10-fund portfolio, that amounts to 17.3 trillion possible portfolio com- binations.
This number is greatly reduced once asset-class restrictions are applied, but it demonstrates the unseen problem in portfolio con- struction.
For every asset class, it is possible to identify three or four outstanding fund choices; typically at this point the most minor of differences becomes the deciding factor, with personal preference playing no small part in the final decision.
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Instead of looking at each fund individually, investors would reap vast benefits if they further leveraged the principle of diversification by studying how funds interact with each other
On the face of it, this looks like a pretty good outcome. A portfolio con- taining a diverse mix of asset classes, populated with the best funds avail- able sounds like a win in anyone’s book; but by ignoring the diversifica- tion effect between funds, huge improvements in the risk-reward profile have been forgone.
Instead of looking at each fund individually, investors would reap vast benefits if they further leveraged the principle of diversification by studying how funds interact with each other.
Active funds do not mirror their underlying asset classes exactly. Dif- ferences in strategy, style, economic outlook, and even the moods of the fund managers, all combine to ensure that no two funds behave alike, and this can be used to our advantage. By analysing the relationship between funds, identifying where these differences offer a significant advantage, we are able to further diversify and lower the overall risk of the portfolio.
FTSE All Share TR in GB Diversification example TR in GB FTSE British Government All Stocks TR in GB
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