The search for true diversification

Diversified balanced and growth funds have long been seen as an easy solution for the core of an investment portfolio, or even the whole of some (especially smaller) portfolios. However, they have not been without their critics.

In the 1980s, most diversified funds used the same in-house investment manager across all assets and some investors questioned whether any one manager had adequate skills across the different asset classes. This led to the development of multi-manager diversified portfolios in the late 1980s and 1990s.

While these allowed for the selection of specialist fund managers in each asset class, most of these multi-manager funds still operated across mainstream assets and investment management styles only. Most adopted similar strategic/benchmark asset allocations with growth-orientated funds predominately invested in equities (especially Australian) and more defensive funds heavily exposed to equities and bonds (again mostly Australian).

Conventional funds

Of course, this is not necessarily a bad thing. As both equities and bonds have performed strongly in recent times (especially in Australia) these funds have generally performed well.

The ultimate ‘conventional’ diversified fund is one built using index funds alone, such as those offered by Vanguard. This implies nothing against Vanguard or indexing as a strategy for some investors. Indeed, Vanguard has actually been one of the better performers among conventional diversified funds in recent years — showing how difficult it is for conventional active diversified and multi-manager funds to outperform their relative return benchmarks.

However, as the difficult period over 2001-02 demonstrated, investors need to be aware how dependent these conventional diversified funds are on a continued upward trend in equity markets and how hostage they are, therefore, to a relatively small number of significant risks.

Conventional funds show a very high correlation to both local and overseas share markets over time. For example, in the three years to November 30, the Vanguard Balanced and Growth funds showed a correlation with the S&P ASX 200 Accumulation Index of 0.92 and 0.94 respectively. Correlation to the MSCI World Index was also very high at 0.76 and 0.75. Most conventional multi-manager diversified funds tend to display similarly high levels of correlation to local and global equity markets.

New trends in diversification

Some investors have long realised this and set about developing more efficiently diversified portfolios and quite ‘different’ diversified funds. Some of this has involved diversifying the equity component (for instance, into global small caps, emerging markets and so on), but this approach alone has significant limitations given the tendency of all equity markets to become more correlated at times of market stress — the very time investors most need the benefits of diversification.

Further enhancements have incorporated a less benchmark-focused asset allocation approach or more use of alternative assets and strategies. The US endowment funds such as Yale and Harvard have been leaders in such approaches, adopting a more absolute return approach consistent with the objectives of many investors. A number of local superannuation funds have moved down this path in recent years.

It is clearly possible to create diversified funds that show much lower correlations to local and global shares in particular. How? There are a variety of ways, but they all involve introducing some non-conventional approaches to asset allocation and investment selection. In my view this can include the following:

Exposure to alternative investments. Alternative strategies (hedge funds, managed futures) and alternative assets (private equity, infrastructure, commodities, precious metals and so on) can help diversify a portfolio and reduce the reliance on equity and bond markets.

They can provide different sources of risk and return to a portfolio and assist in providing a smoother path of returns over time.

Flexible asset allocation. I do not believe investors should have a high degree of confidence that they can set in advance a specific strategic or benchmark asset allocation that will definitely meet their return and risk objectives over time — even over the long term. At a time when equity markets have performed well in recent decades and on most measures are towards more expensive levels compared to their long-term history, one can be even less confident.

Broad asset ranges and a significant degree of flexibility can thus be introduced within those ranges without any strict adherence to competitor or market weightings. There can also be much greater flexibility to target sectors and themes that are seen as attractive and to hold large exposures irrespective of index weightings.

A focus on absolute return-oriented managers. With absolute returns a key objective to building a ‘different’ diversified fund, one should seek managers who are focused on achieving positive returns irrespective of what the market benchmark does. Some of these managers operate long-only approaches, while some have the flexibility to take short positions or use derivatives to manage risk.

Usually, but not always, they are boutique or specialist organisations. Typically, they have a contrarian or value focus and may well have wide flexibility to focus on small as well as large cap stocks.

The use of listed investment vehicles. In Australia, and in most global stock markets, there are a number of listed investment funds that trade at varying levels of discounts and premiums to the value of their net tangible assets (NTA) — usually discounts. Some of these are run by high quality investment managers in attractive sectors and are sometimes not available in an unlisted form.

If selected well, investors can benefit from a ‘double whammy’ good performance of the underlying assets and the benefit of a narrowing in the discount to NTA over time. For example, excluding tax issues, if you buy a fund at a 20 per cent discount to NTA and the discount narrows to 5 per cent over a year and in addition the underlying fund returns 10 per cent, your one-year return is actually 31 per cent per annum.

Buying at a discount to NTA can also reduce the risk of exposure to certain areas. Most conventional multi-manager funds exclude these listed funds from their investable universe.

The point is not that introducing these elements results in lower or higher risk compared to a conventional diversified fund — that partly depends on your definition of risk — but rather, they are about introducing different risks and operating from a more absolute return perspective, which is more in line with many investors’ needs.

A combined approach. Indeed, a combination of a conventional diversified fund and a more absolute return oriented diversified fund may be beneficial to many investors. A 50/50 combination of a conventional fund and a more absolute return-oriented fund may well significantly improve the investor’s experience from a risk return perspective (using standard quantitative measures of risk).

One may improve the Sharpe Ratio (a commonly used measure of risk-adjusted returns) and reduce the maximum drawdown (that is, the worst negative return over the period analysed) simply because the two different approaches can earn their returns at different times.

Diversified funds clearly have a role for many investors, but investors and advisers need to understand clearly what they are buying. Are they investing in a toned-down equity fund or are they accessing a diversified fund that can access the full spectrum of investment opportunities while having the flexibility to skew towards the most attractive ones?

At some point, mainstream equity and bond markets will perform poorly again and there is clearly a risk of a mismatch between some investors’ expectations that their funds are widely ‘diversified’ and the reality that many are predominantly exposed to equity and bond market risks.

However, there are ways to reduce this risk. Diversifying diversified funds to include those investments that are truly different may well be an answer, and in doing so one can provide clients a smoother path of returns over time.

Dominic McCormick is chief investment officer of Select Asset Management .