Marc Odo, director of research at software and business intelligence firm Informa Investment Solutions, revisits some of the forgotten truths about diversification.

Opinions are the author’s but WealthBriefing is grateful for the right to publish them, and welcomes reader responses.

In the wake of the financial crisis five years ago, many investors are questioning the value of diversification.  For decades, the financial industry preached the idea of spreading out one’s investments across a broad collection of assets to mitigate risk. However, as markets plunged in unison in late 2007 through early 2009, the losses incurred were much higher than anticipated. This has spawned much debate over the usefulness of maintaining a diversified portfolio.

Why did diversification fail during the credit crisis? Was it a problem with the theory or the practice? I believe it was a bit of both. Many advanced mathematical theories are being discussed in academic circles to find better ways to quantify and model downside risks. But how these models are implemented is just as important.

Diversification promised that, by investing in uncorrelated assets, losses in one portion of the portfolio would be offset by gains in another portion. Overall, this produced a smoother, less volatile ride. But the opposite of that idea was lost along the way: if a portfolio’s investments are highly correlated, then volatility wouldn’t be reduced at all.

Homogenisation

During the years preceding the financial crisis, the political and economic trends had the unintended effect of increasing the correlations between asset classes. The European Union’s mission was an “ever-closer union”.  By removing barriers to trade; harmonising laws and regulations; and introducing a common currency, the EU was creating a single market. 

While this crusade was largely beneficial in increasing economic efficiency and reducing costs, an underappreciated side effect was that the opportunities to diversify were being whittled away. An economic event that might have produced a wide range of responses across different markets a decade or two ago had a much more uniform impact on markets as economies converged.

Of course, this convergence wasn’t limited to just Europe. The conditions that led to the credit crisis were truly global in nature. The abundance of liquidity, lax lending standards, securitisation and the property boom were worldwide phenomena during the mid-2000s. Global financial markets knew no borders, and thus their fates were tied tightly together. Diversification options were becoming scarcer, but as equity and property markets boomed, no one seemed to mind until it was too late. 

Today, investors are returning to the original intent of diversification: owning investments that truly behave differently. The opportunity set of potential investments has expanded to include entirely new asset classes once considered too exotic. Hedge funds, currency strategies, commodities, real estate, precious metals and emerging market debt are all part of the portfolio conversation these days. Pushing the envelope, asset classes like private equity, farmland, timberland, infrastructure projects, water rights and carbon emission rights are potential investments for certain risk profiles. 

Such investments are not for suitable for everyone. These alternative asset classes carry unique and sometimes underappreciated risks. Liquidity risk or political risk might not show up in measures of volatility, but it could be the primary source of risk in these asset classes. Information is much harder to acquire and interpret; traditional valuation models might not apply. Truly understanding these asset classes requires investors to think about their investment differently. However, that’s the point of these new asset classes: their risks are idiosyncratic and not systemic. This is how you achieve diversification.

Changing tastes

Investors are also diversifying their portfolio by granting their active managers much more freedom and flexibility to seek out profitable opportunities wherever they might find them. The pendulum is swinging away from benchmark-tracking funds that seek to add an incremental 1-2 per cent per year over an index.  Investors were happy to track a benchmark on the way up, but are understandably reluctant to track a benchmark on the way down. As a result, active managers with successful track records of identifying the most profitable opportunities across the investment spectrum are enjoying a resurgence in popularity.

That being said, a truly diversified portfolio will inevitably have investments that occasionally underperform.  Different asset classes will periodically fall out of favour, and even the best active managers will have bouts of poor performance. For example, one could build a strong case that carbon emission rights make for an excellent diversification option. However, it’s much more difficult to see the benefits if you purchased your carbon rights at 30 euros a ton and they’re now trading around 5 euros. When discussing diversification, a simple but forgotten truth is that if everything in your portfolio is going up at the same time, you are not diversified.

The original objective of diversification was to maximise returns and minimise risks. These goals remain the same and are as important as ever. The biggest challenge today’s investor faces is to diversify in a globalised world.