Diversification is an important risk management strategy and a core ingredient of investment success.
It can’t promise that investors won’t suffer losses in their portfolio, but it aims to deliver steadier returns and a smoother ride by spreading risk via a mix of asset classes and risk factors that are lowly or negatively correlated to each other.
The logic is flawless: don’t put all your eggs in one basket because no-one can predict which will be the next outperformer.
When one asset class ‘zigs’ another can ‘zag’, but diversification can provide some downside protection while smoothing out a portfolio’s ongoing returns.
However, there’s much more to constructing a robust, well-diversified portfolio than simply holding a few major banks, a couple of miners, a retailer,
a telco and some listed property.
This is a poorly diversified portfolio.
Traditional balanced superannuation funds, which follow a rudimentary strategic asset allocation (SAA) formula of roughly 60 per cent in growth assets (mainly Australian and international equities) and 40 per cent in defensive assets (mainly cash and fixed income), are also poorly diversified.
The shortcomings of this overly simplistic approach were exposed during the global financial crisis, when almost every asset class plunged in unison.
Outdated and ineffective approach
Still, many super funds and fund managers cling to this outdated and ineffective approach, leaving their members concentrated in a small number of closely correlated risk factors and exposed to considerable risk.
The term risk factors may sound like technical mumbo jumbo but it basically refers to the drivers of an asset’s return.
All investments carry a degree of risk that impacts on their potential return. A risk factor is an underlying source of that return, and investors should concentrate on those factors that provide them with a positive return over time.
In short, risk factors can be split into two broad categories: macro factors and style factors. Macro risk refers to financial risk associated with macroeconomic or geopolitical factors. Macroeconomic risk variables that should provide investors with a positive rate of return include GDP growth, inflation and the credit risk segment of the market.
Style risk factors include an asset’s price and valuation, profitability of the underlying companies and credit rating of the securities issued. A fund manager’s skill and ability to pick winners is another individual risk factor, as is a security’s momentum.
When constructing a portfolio, the key is to diversify across risk factors and prevent doubling or tripling up on the same risk factors.
It’s not enough to invest in a broad variety of asset classes if those asset classes are exposed to the same underlying risk factors.
For example, equity risk (which represents the bulk of the average balanced fund’s risk budget) is concentrated in macro and valuation (style) risk.
Therefore investors who believe a growth portfolio made up of Australian equities and international equities is providing them with adequate diversification may be heavily exposed to economic and valuation risk. In fact, this could be contributing to more than 90 per cent of the return volatility in their portfolio.
If underlying stocks were purchased at a fair price then value won’t be a major return driver, rather economic factors will drive performance. On the other hand, valuation will play a major role if stocks were bought cheaply or if you overpay for them.
The sources of return
A simple way to approach portfolio construction is to list the different sources of return available, such as revenue and profit, capital appreciation tied to undervalued securities, yield and economic prosperity which can impact a stock’s valuation and profitability.
Next, look at the underlying risk factors those return sources are exposed to.
Examine how the various risk factorschange throughout time and how they operate independently as well as their relationship with each other. This leads to the concept of non-correlated returns.
It’s highly uncertain how asset classes will correlate over time. It’s generally accepted that the performance of equities and bonds are negatively correlated, meaning when equities go down, bonds go up and vice versa, however, history shows that this relationship is in fact very dynamic.
Ultimately, investors who want a well-constructed portfolio must include many independent and differentiated sources of risk and return, but importantly, pay attention to price. At the end of the day, investors must make sure they don’t overpay.
Diversification by risk factor
Many people think that a well diversified share portfolio is one that’s invested across different sectors, namely mining and resources, financials, retail and telecommunications. But that’s a very limited and crude approach to diversification. It’s far more effective and intelligent to diversify by risk factor.
Within every asset class there are underlying risk factors. In equities, there are companies trading at a discount to the market (value stocks), companies that are more profitable than the broader market (quality stocks), and companies with lower volatility (lower beta stocks).
There are likewise companies with strong momentum.
Investors can also diversify by size, given quality smaller companies tend to outperform large caps over the long term.
These companies generally outperform the market over the longer term.
For those who want to invest in value companies, a basic proxy is a company’s price-to-book ratio, which is publicly available information. Price-to-book effectively compares a company’s stockmarket price to its book value.
A basic method of determining value is to use a spreadsheet to rank companies, based on price-to-book, and invest in the top quartile to create a value tilt in a portfolio.
Investors who want to lift their exposure to quality stocks can create a spreadsheet to rank companies based on factors such as earnings per share, return on equity and leverage.
Similarly, those keen to lower a portfolio’s volatility may rank stocks according to their volatility and then invest in more stable companies. Diversifying in this way delivers a more defensive portfolio.
Bonds
When it comes to fixed income, the two key risk factors are duration, or interest rate risk; and credit, or counterparty risk. Investing in a diversified portfolio of bonds of varying duration and credit rating can minimise interest rate and counterparty risk.
Investors shouldn’t be put off by the term ‘duration’. An easy way to understand the concept of ‘duration risk’ is to consider a three-year term deposit with a fixed interest rate of 2.65 per annum. During that time, there’s a risk that interest rates will rise, meaning investors will receive a lower rate of return than the prevailing market rate over that three-year period.
The degree of an investor’s exposure to interest rate risk is directly related to the length of time, or duration, of their bond’s fixed term. Investors should be adequately compensated for interest rate risk.
Furthermore, duration is closely linked to inflation risk because higher inflation typically leads to higher interest rates.
Credit risk is the other major risk factor in bond investing. Again, investors shouldn’t be confused by the term credit. In short, it’s about the quality
of the company an investor is lending money to, which is why it’s often called counterparty risk.
While it’s often assumed that buying a highly-rated bank bond or government bond is risk free – in other words, there’s zero chance of the counterparty defaulting – there are no guarantees. When an investor lends to any counterparty, there’s always a chance they won’t get the full amount of their capital back.
They should be adequately compensated for taking on that risk.
Property
The other obvious asset class to consider is property.
When it comes to residential property, the main risk factor is supply and demand of land exposure, while in commercial property it’s domestic GDP growth and productivity. Both are loosely linked to inflation.
Given that inflation, GPD growth and demand of land are all generally positive throughout time, investors are usually compensated for the risk they take on, provided they don’t overpay.
Property investors who are experiencing gains of around 10-20 per cent per annum should also be very wary.
The importance and value of diversifying by risk factor
How much or how little exposure an investor should have to different risk factors will depend on their financial needs and objectives, and their capacity
and tolerance for risk. Each risk factor carries differing degrees of risk.
Those who outsource portfolio construction and investment management to an external research house, asset consultant and/or fund manager, are also exposed to manager skill.
In return for taking that risk, they should be compensated in the form of higher returns, (although more often than not investors aren’t).
While the popular adage ‘don’t put all your eggs in one basket’ is true at the individual security level and asset class level, it’s also pertinent at the risk factor level. Sophisticated investors should think intelligently about diversification and diversify across a range of risk factors.
Having said that, building and managing an intelligently diversified portfolio is very difficult to do and monitor on an ongoing basis, because whenever an underlying asset’s price changes (which is all the time), the risk attached changes. That’s why it’s critically important to seek professional advice.
