Risk diversification in multi-manager products

Beyond making the investment fund selection process much simpler, one of the primary reasons that investors are attracted to multi-manager funds is diversification.

The selection of a range of managers and asset classes increases the diversification of an investment, helping to cut investment risk.

Evolutions in portfolio construction are, however, showing that the average diversified fund (single or multi-manager) is failing to adequately allow for the changing dynamics of investment markets, including market cycles, and carries significant market risk as a result.

Take your standard 70:30 diversified growth fund for example, with an asset allocation of Australian shares (32 per cent), international shares (31 per cent), Australian bonds (11 per cent), international bonds (11 per cent), property (7 per cent), cash (5 per cent), and other (3 per cent).

From an asset allocation perspective, the fund appears to be well-diversified.

However, when constructing diversified funds, it is important to consider not just the exposure to asset classes, but also the exposure to various ‘risk buckets’ or groups of assets that are expected to perform in a similar manner through a market cycle.

Clearly, there is a shares bucket. Domestic and international shares capture economic growth, and while one could argue the benefits of international diversification, globalisation means domestic and international shares have enough in common to be in the same risk bucket.

There is also a bonds bucket. In general, bonds will provide downside protection in a recession, and will not perform as well in an inflationary environment.

What the risk bucket approach reveals is that the average so-called diversified fund is heavily reliant on these two risk buckets —equity and bond markets — to meet long-term return requirements.

The inherent risk that this formula involves in the event of a market downturn is significant.

We have all seen this phenomenon in play: the 2001 tech market crash is a prominent recent example.

Following the downturn in international equity markets post the tech crash, the average diversified fund produced sizable negative returns despite being ‘diversified’.

Risk concentration and a dependence on equity and bond market beta become even more problematic when you consider some of the emerging changes in how the market operates.

With the Australian share market having run fairly hard over the past several years, many advisers are wondering how much further the market can climb and are considering rotating assets.

But changing market dynamics mean that the traditional strategy of rotating out of equities into bonds and property may not work so well anymore.

With increased globalisation, the correlation of traditional investment markets has intensified, as shown in Chart 1 (Money Management, July 26, Page 25). This means that a given event may have the same directional impact on both equity and bond markets.

Added to this, the ability of traditional defensive asset classes such as listed property trusts and benchmark-aware fixed interest exposures to anchor a fund’s performance in the event of a market downturn has become increasingly difficult.

In the case of listed property, the changing composition of the sector towards more stapled securities has strongly increased its correlation with equity markets.

Meanwhile, now that corporate debt makes up a larger portion of bond indices, the correlation between equity and debt markets has increased, as both will be impacted by the view of the underlying companies.

If we link this back to the risk buckets, the average diversified portfolio is now exposed to a significant amount of equity and bond risk, which has become increasingly correlated. As a result, the potential downside in the average diversified portfolio in the event of a shock is considerable.

So what can be done to get proper diversification in a portfolio across investment cycles?

At the outset, it is important to note that while the correlation of traditional markets has increased, it has not grown to the point where investors should reconsider holding a combination of these traditional assets in their portfolios.

Rather, the reliance on shares and bonds can be reduced by adding investments that behave differently and are not dependent on traditional markets (that is, a third risk bucket).

This means that while equity markets are still going to account for a significant part of a portfolio’s return and risk, the investor is not as exposed and the portfolio should perform more consistently through a cycle.

Alternative investment strategies offer the ideal solution. Alternatives tend to have a reputation for being higher risk — while this is certainly true of some alternatives, there are other strategies that aim to reduce risk.

Alternatives also incorporate more than just hedge funds, and may include diversifying beta strategies such as infrastructure, commodities and direct property.

The key with alternatives is understanding the underlying risks of the various strategies, how they correlate with traditional markets and how to bring them together to create the appropriate exposure to match the risk profile of a portfolio.

The practicalities of this approach can be readily demonstrated:

Take an average superannuation fund with the following investment criteria:

> investment objective — consumer price index (CPI) +4 per cent;

> time horizon — seven years;

> risk profile — moderate;

> risk target — one in five years negative return; and

> growth allocation — 70 per cent.

The typical allocation of this type of diversified fund currently includes shares (65 per cent), nominal bonds (22 per cent), property (5 per cent) cash (4 per cent) and alternatives (4 per cent).

Without some adjustments to improve diversification, this type of fund today faces a significant concentration of market risks.

The latest thinking suggests that the optimal allocation should include a significant boost in the alternatives portion.

As a result, our sample superannuation fund would look more like shares (55 per cent), nominal bonds (16 per cent), property (7 per cent), cash (3 per cent), and alternatives (19 per cent).

Importantly, making this change doesn’t have to compromise the return of the portfolio.

In fact, Skandia’s research has found that making this change reduces the risk of the portfolio, as measured by standard deviation, and increases the probability of the portfolio meeting its return objective.

This is reflected in Charts 2 and 3 (Money Management, July 26, Page 25), which depict the risk return profile of our sample fund before and after the change in allocation to alternatives.

Of course, this approach can’t promise a magic cure in the event of extreme market shocks. However, stress test modelling shows that it can improve the downside risk in the portfolio.

In summary, today’s portfolio construction aims to ensure that an investment fund is diversified by manager, asset allocation and risk bucket.

To be diversified by risk bucket, investors will need to incorporate a larger allocation to alternatives in their portfolios. And this is where the value of multi-manager strategies becomes clear.

Managing alternative assets requires a diverse and highly specialised skill-set not likely to be found within the one management firm.

Added to that, alternatives are generally more complicated strategies that require a higher degree of monitoring and understanding — a skill that the multi-manager can deliver.

Finally, there is no one-size-fits-all solution when it comes to alternatives, rather, the types of alternatives exposures need to vary depending on the investor’s chosen risk profile. The expertise of the multi-manager is essential to ensure this is achieved.

Regardless of where local and global markets are heading, multi-manager funds have just got a lot more attractive.

Jody Fitzgerald is head of retail investment services with Skandia’s Investment & Consulting division .