Diversification: Clever, complex and critical
An intelligent approach to diversifying portfolios can have a significant impact on returns for investors. Dolfin’s CEO Denis Nagy and Vassilis Papaioannou from its investment team explain why effective diversification is far more complex than simply spreading a portfolio thinly across asset classes or investment styles. (First published on the Dolfin website on 30 May 2016.)
Investors — wherever they are in the world — should use diversification to protect their wealth and achieve growth. That much is widely known and accepted as common sense. But the key to success lies in a deep understanding of the risks that portfolios contain and what each client’s appetite for risk truly is.
Portfolios can be diversified by asset class and by investing style. The Yale model, sometimes called the endowment model, is held up as an example of “real” diversification, across strategies, markets and geographies. By shifting a significant portion of investments away from traditional stocks and bonds and investing into absolute return strategies, international equities and real assets or niche private markets, with a high allocation to equities, skilled investors are able to achieve superior returns.
Other investors may adopt different approaches but the choice of asset class remains broadly the same: equities — international and domestic; fixed income in the form of government, investment grade or high yield bonds; and commodities — energy, metals or agricultural. Then there are so-called alternatives that can be further split into the hedge funds or real estate. Lastly, there is likely to be a proportion of cash.
But if diversification by asset class can take different forms, so can the investment styles employed within a portfolio, reflecting an investor’s own preferences and prejudices. Both active and passive styles may have a role to play and the crucial factor when deciding on a style is a clear understanding of risk.
The key to success lies in a deep understanding of the risks that portfolios contain and what each client’s appetite for risk truly is.
“Understanding the underlying risk factors is important for clients,” explains Dolfin’s CEO Denis Nagy. “You can exploit the exposures to these different factors using different asset classes but what really takes it to another level is your investment approach in showing clients what factors they are truly exposed to. You need to offer a transparent look through the approach that leads to a clear understanding of the driving forces behind the portfolio.”
As we’ve written about in the past, many investors choose to invest in areas or sectors that they understand, or which they may, for example, be engaged in through the nature of their work or personal history. This makes sense but it also results in a concentration of risk, which could result in exaggerated losses, should that sector or area encounter difficult times.
“We can identify behavioural biases on a retail or an institutional level,” says Vassilis Papaioannou of Dolfin’s investment team. “They can be mitigated by having a well-diversified portfolio. If a UK-based investor has five or six UK equity holdings, that portfolio is not well diversified within equities or within certain names. So we can begin to add more diversifying forces in order to be well positioned for the future and, to some extent, to be able to mitigate some of the general biases that the investor has. This leads the investor to access different sources of risk and incorporate some low level of correlation within this asset class. The more ingredients the portfolio has and the longer the horizon, the better.”
“We have clients for whom the idea of losing any money in any month is unbearable” — Denis Nagy, CEO, Dolfin
Nagy summarises by placing the diversification approach into a wider, personal context. “Clients, on a daily basis, invest their human capital into their employers, how they spend their time, their families and that is where their risk is taken. That defines their ability to take risk when it comes to financial markets.
“It is very important that we make an assessment of clients’ ability to take risk. And there are also psychological aspects. We have clients for whom the idea of losing any money in any month is unbearable. Others accept that the portfolio may underperform in one month but make up for any losses over the longer term. Our goal, through our risk management framework, is to help them rationalise their diversification across asset classes, styles and risk factors in order protect their wealth and gain optimal returns for the degree of risk they are prepared to take.”
Only by understanding the investor’s preferences, short- and long-term goals, and above all appetite for or aversion to risk is it possible to create a portfolio that limits exposure to market under-performance and delivers consistent returns.
Before it’s here, it’s on the Dolfin website.