Diversification a paradox for investors

1
Diversification - a paradox for investors?

• William De Vijlder, Global Chief Investment
  Officer
• 5 May 2009

2
Three (hypothetical) statements

• Diversification didnt work in 2008 because both
  market volatility and correlations increased
• The recent rally in risky assets has again seen
  a high correlation amongst asset classes. Why not
  adopt a concentrated, non-diversified strategy?
• Diversification is something you benefit from
  when you dont need it and that disappears when
  you need it most

3
Read on IPE.com
Providers say traditional diversification needs
rethink IPE.com 16 April 2009 1600 EUROPE
Classic balanced or multi-asset mandates have
failed to protect pension funds during the
current crisis and need to be reconsidered,
according to both Allianz Global Investors and
German consultancy Heubeck Feri. Many systems
for analysis and early warnings have to be
reconsidered and some new investment
restrictions, be it internally or externally,
might have to be put in place, argued the
Heubeck Feri in a statement. Officials at Allianz
Global Investors (AGI) also agree there might be
more regulation and, like Heubeck Feri, stressed
the need for changes to risk management systems.
In the current crisis, as in other extreme market
situations, diversification effects often
disappear and traditional balanced or multi-asset
mandates cannot fully protect against downward
movements, claimed AGI in a paper on risk
management. High volatility and correlation have
unveiled as yet unnoticed risks in the asset
allocation which have to be addressed with the
right risk management measures, Heubeck Feri
also pointed out. Allianz suggested there is a
need to move away from the classic bond/equity
benchmarks towards a more dynamic asset
allocation, to help manage risk long-term...
4
EDHEC however makes a plea for solid portfolio
construction i.e. diversification

• The feedback received from the industry confirms
  that industry practitioners are largely convinced
  of the benefits of advanced portfolio
  construction techniques. In their view, the main
  barrier to widespread adoption of these
  techniques is the lack of knowledge in the
  industry, not implementation costs or a lack of
  client interest.
• 95 of the practitioners who responded share
  EDHEC's opinion that improvements need to be made
  to portfolio construction practices. Even though
  the recent events in financial markets are likely
  to increase investors' needs for portfolio
  construction that take into account extreme
  market scenarios for various asset classes,
  investment managers do not fully take into
  account extreme risks when constructing
  portfolios. They also fail to employ techniques
  that avoid generating overly-concentrated
  portfolios because of poor input estimation.
• 86 of the professionals responding to the
  questionnaire report that further education and
  effort on the part of investment managers are
  highly important in closing the gap between
  real-word practice and academic research.

Source EDHEC e-mail announcing "A Long Road
Ahead for Portfolio Construction Practitioners'
Views of an EDHEC Survey http//docs.edhec-risk.
com/mrk/090313_Publication/EDHEC_Publication_Portf
olio_Construction.pdf
5
Experience since 2000
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Half year rolling window correlation
global eq. vs commodities
1.00
0.80
0.60
0.40
0.20
0.00
-0.20
-0.40
-0.60
Jun-02
Jun-03
Jun-04
Jun-05
Jun-07
Jun-08
Jun-00
Jun-01
Jun-06
Dec-00
Dec-01
Dec-02
Dec-03
Dec-04
Dec-05
Dec-06
Dec-07
Dec-08
Correlation changes sign and increases
dramatically
7
Half year rolling window correlation
global eq. vs US HY
1.00
0.80
0.60
0.40
0.20
0.00
-0.20
-0.40
-0.60
-0.80
Jun-03
Jun-04
Jun-05
Jun-08
Jun-00
Jun-01
Jun-02
Jun-06
Jun-07
Dec-00
Dec-01
Dec-02
Dec-03
Dec-04
Dec-05
Dec-06
Dec-07
Dec-08
Rising trend towards ever higher positive
correlation in good times and bad times
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Half year rolling window correlation
global eq. vs EURO invest. grade
0.40
0.20
0.00
-0.20
-0.40
-0.60
-0.80
Jun-00
Jun-01
Jun-02
Jun-03
Jun-04
Jun-05
Jun-06
Jun-07
Jun-08
Dec-00
Dec-01
Dec-02
Dec-03
Dec-04
Dec-05
Dec-06
Dec-07
Dec-08
Negative correlation is the norm, positive
correlation the exception. Second half of 2008
and early 2009 have been exceptional.
9
Half year rolling window correlation
global eq. vs EURO gov. bonds
0.40
0.20
0.00
-0.20
-0.40
-0.60
-0.80
-1.00
Jun-00
Jun-01
Jun-02
Jun-03
Jun-04
Jun-05
Jun-06
Jun-07
Jun-08
Dec-00
Dec-01
Dec-02
Dec-03
Dec-04
Dec-05
Dec-06
Dec-07
Dec-08
Negative correlation is the norm, correlation is
rarely positive.
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Why diversify?
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Its the only free lunch
Risk of a portfolio invested 50 in European
Equities and 50 in Euro government bonds
Risk
A substantial decrease of risk can be obtained
through drastic diversification (with equal
expected return).
100
Another way of looking at the benefits from
diversification the risk reduction allows the
investor to leverage his optimal portfolio so as
to achieve the initial absolute level of risk but
with a significantly higher expected return (the
extra return being the difference between the
portfolio return and the borrowing cost)
90

• We have added the following assets
• Global Equities
• Credits
• Convertibles
• Small caps
• Real estate
• EMD
• High yield bonds

80
70
60
50
0
1
2
3
4
5
6
7
Number of asset classes added
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Why bother about a free lunch even if its free

• Not taking a free lunch would be inefficient from
  an investment perspective
• Technical answer
• avoid generating overly-concentrated portfolios
  because of poor input estimation. (EDHEC)
• To put it differently
• Estimates of long term expected returns are
  uncertain
• A risk averse investor is not living in a Monte
  Carlo world
• you only live once versus 10.000 simulations
• A risk averse investor is also interested in
  realised returns since initiating his portfolio
  even though the remaining investment horizon is
  still long
• For this reason diversify to smooth out return
  volatility

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You only live once asset allocation is the key
return driver
Factors Explaining Dynamics of Returns over Long
Horizons
2.1
1.8
4.6
91.5
asset allocation
security selection
market timing
other factors
Source Brinson, Beebower, Singer (1991)
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Diversification the long term experience
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Smart Benchmarking extreme circumstances in
Q4 2008 weigh on return
Past performance or achievements are not
indicative of current or future performance
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Diversification lessons of 2008

• The 2008 crisis was unique in its speed, jump in
  correlation and illiquidity
• However, generally correlations will rise sharply
  during a financial crisis
• Thus diversification provides no crash
  protection.
• . it offers protection by building up a buffer
  (accumulated outperformance) during non crisis
  years
• Diversification works in the long run

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Why did correlations rise so much in 2008?

• Before the crisis, risk budgets were being used
  to a significant extent. These were or had to be
  cut back during the crisis (generalisation of
  CPPI type of management)
• Spillover effects in the real side of the economy
• The developed world was exporting its problems
  to the emerging world
• As a consequence, emerging markets expected
  returns were hit as well
• The same applies for commodities
• Financial contagion
• Cross-over buyers cutting back their positions
• Deleveraging
• Market illiquidity

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Does Smart Benchmark work?
Synthetic History of Monthly Rebalanced
Portfolios Returns
5,000
Smart Benchmark Allocation
4,500
4,000
3,500
3,000
Strong cumulative excess return illustrates
effect from exposure to high expected return
asset classes whilst keeping risk under control
(compared to traditional benchmark) via
diversification
Index of Returns (Dec 1969 100)
2,500
2,000
1,500
Traditional Benchmark Balanced
1,000
500
0
1969
1970
1971
1972
1973
1974
1975
1976
1977
1978
1979
1980
1981
1982
1983
1984
1985
1986
1987
1988
1989
1990
1991
1992
1993
1994
1995
1996
1997
1998
1999
2000
2001
2002
2003
2004
2005
2006
2007
2008
2009
Dates
Source Thomson Datastream, Fortis Investments
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What about tactical diversification vs
concentration?

• Tactical refers to tactical positions,
  diverging from the benchmark
• Tactical asset allocation
• Sector allocation
• Style allocation
• Stock selection
• The theoretical argument for diversification is
  strong and is based on the fundamental law of
  active management
• Information ratio (excess return divided by
  tracking error) is a function of investor skill
  (information coefficient) and the number of
  de-correlated bets
• Very concentrated portfolios (very limited number
  of bets) can only be justified provided
• The investor has a very high conviction level
• The investor has a good track record
• A stop-loss strategy is in place

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Conclusion
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Diversification is dead. Long live
diversification!
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Diversification still a good idea

• The theoretical basis (a free lunch) is still
  valid
• Diversification protects the investor against
  building very concentrated portfolios which
  crucially depend on the correct estimation of the
  expected returns
• Good diversification allows to address the issue
  of unexpected shocks
• Inflation shocks
• Growth shocks
• Interest rate shocks
• Inevitably, extreme market circumstances will
  decrease the diversification benefits
• Solution tactically reducing the overall risk
  budget
• The case for tactical diversification is very
  strong. Tactically concentrated portfolios
  require high conviction levels and good track
  record

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informational purposes and does not constitute 1)
an offer to buy or sell or a solicitation of an
offer to buy or sell any security or financial
instrument mentioned in this document or 2) any
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suitability and consequences of an investment in
the securities. The opinions contained herein are
subject to change without notice. Investors
should ensure themselves that they read the last
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current or future performance. The performance
data do not take account of the commissions and
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