B. Venkatesh

Wealth managers and portfolio managers always recommend investors to diversify their portfolios. Diversification did not, however, save the portfolios from the carnage that saw asset prices tank last year. Investors are understandably sceptical about the benefits of diversification. The question is: Should investors hold diversified assets?

This article discusses the concept of diversification and the downside to holding diversified portfolios. It then shows why investors should hold multi-asset class portfolios and demonstrates the relevance of such portfolios within a core-satellite framework.

Correlation asymmetry

Diversification is different from asset allocation. Asset allocation refers to the process of taking exposure to more than one asset class. An investor, for instance, may decide to allocate 40 per cent of her assets to stocks, 40 per cent to bonds and 20 per cent to alternative assets such as gold and arts.

Diversification is the process of buying different assets within a single asset class. The investor, having decided to allocate 40 per cent to stocks, may choose to buy four different equity funds or 15 different stocks.

The argument is that taking exposure to number of stocks spreads the risk; for all stocks will not decline at the same time. Or even if they do, not all of them will decline by the same magnitude.

A diversified portfolio is constructed based on correlation structures. Suffice it to know that correlation captures the relationship between two stocks; lower the correlation, higher the diversification.

The problem is that correlation is asymmetrical. That is, when assets climb up, the correlation is weak. But when the same assets decline, their correlations get stronger! It is because of correlation asymmetry that even diversified portfolios took a beating during the market crash last year.

Does this mean portfolio managers should not apply the principle of diversification? Not really.

Professional money managers construct institutional portfolios after considering correlation asymmetry.

Retail portfolios are, however, not adjusted for such correlation structures. Asset allocation, therefore, becomes more important than diversification.

Multi-asset class portfolios

Empirical evidence suggests that 90 per cent of variability in returns across time for a typical balanced fund is explained by its asset allocation policy.

This essentially means that a carefully crafted asset allocation strategy carries more value than the security selection process. Hence, the suggestion for multi-asset class portfolio.

Besides, such a portfolio plays well with investor psychology. Here is why.

Investors’ risk appetite is tiered. That is the reason many buy life insurance policies (hedging basic risk) as well as lottery tickets (gambling with additional money). It is no different with financial assets.

The base of the risk pyramid has cash equivalents (least risky), followed by fixed-income, stocks and alternatives.

A multi-asset class portfolio reduces overall volatility and satisfies an investor’s desire to take exposure to risky as well stable assets.

The principle idea behind the strategy is to add stable cash flows (fixed-income securities) to a set of volatile assets (stocks and alternatives).

The advantage in combining bonds and stocks is that the primary risk drivers are different. Stocks are primarily sensitive to earnings volatility while bonds move to interest rate changes.

The multi-asset class portfolio essentially bets that adverse effects (earnings decline and interest rate hikes) will not strike both the asset classes at the same time. While “non-normal” markets could still lead to multi-asset class declines, the likelihood is far lower than in the case of diversification, where all securities within an asset class typically tank.

Conclusion

The multi-asset class portfolio sits well within the core-satellite framework. A typical portfolio could have equity exposure to one low-cost index fund (called the passive core), fixed-income exposure to term deposits and tax-advantaged investments such as public provident fund.

The satellite portfolio could contain exposure to, say, one mid-cap fund, one emerging market fund (for enhanced returns) and commodity futures. Such a portfolio, leaning more on asset allocation than on portfolio diversification, would be easy to manage.

(The author is an investment strategist. He can be reached at enhancek@gmail.com)

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(This article was published in the Business Line print edition dated April 5, 2009)
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