Diversification alone is not enough

The promise of \"\"diversification\"\" has been used to attract investors to many alternative asset classes over the years. But any asset held in a portfolio should be there on its own merits.

Every so often, an asset class manages to establish itself on the fringes of a “typical” investment portfolio. With the passage of time, and the aid of effective marketing strategies, some of these asset classes are able to make the leap from fringe to mainstream. Back in the 1980s, investors were introduced to the merits of junk bonds as a way to finance the leveraged buyout boom. Going further back, the mortgage-backed security market was created to allow banks to free capital on their balance sheets by introducing liquidity to an otherwise illiquid asset.

In both of these examples, when it came to persuading investors to accept these fledging asset classes, the real reasons for their creation were conveniently circumnavigated. Instead, carrots such as higher returns and, in particular, diversification were dangled in front of portfolio managers to convince them of the merits. Little has changed since. Junk bonds have, in part, been replaced by certain hedge fund strategies as a means to finance buyout activity, while credit derivatives can be a useful method for banks to repackage risk exposures that they would rather not carry on their own balance sheets.

I do not question the view that the advent of mortgage-backed and high-yield bonds, together with hedge funds and credit derivatives, are all positive developments. As risk is more finely sliced and diced, these asset classes allow investors to be choosier and more innovative in the selection of risks to which they expose themselves.

The issue is not whether these products should ever have been created, but rather, how they are often marketed. Building on the work of Harry Markowitz, who in the 1950s introduced the mathematics of diversification with concepts such as volatility and correlation to build “efficient” portfolios, marketers have picked up the basic message and used it to push the merits of any new asset class that comes along.

Using the principles of diversification, it can be shown that the introduction of any asset that is not perfectly correlated with the rest of the portfolio always provides an opportunity to reduce the volatility of returns. Since volatility is generally accepted to represent risk, the angle of attack is always the same: “Use this asset class and reduce your risk”.

There are problems with this simplistic, yet persuasive, approach. First of all, the Markowitz model assumes the correlation between two asset classes is constant. The chart above, which shows the correlation between the FTSE 100 and the Mexican Bolsa (Mexbol), proves this is not the case. Taking this argument further, studies have also shown that during down markets – that is, when diversification is most needed – correlations between asset classes tend to increase dramatically.

Volatility as a measure of risk is another problem. The infamous Long-Term Capital Management hedge fund had displayed remarkably consistent monthly returns, with little volatility, prior to August 1998, yet it then produced a loss of more than 40% for August and followed it up with a decline of 80% during September.

Another issue is cost and liquidity. While an investment in an alternative asset class may bring diversification benefits, what is the cost associated with doing so? Many of the alternative asset classes that come across my desk from marketing groups – including investment opportunities in stamps and wine, for example – have so many levels of intermediation and restrictions on realising monies that any returns that may be available are severely eroded by the costs involved.

Which brings us neatly to the most fundamental problem with how some of these asset classes are promoted. Among the myriad of pitches for alternative assets caught up in proclaiming the merits of diversification, somewhere along the way the investment case based upon the potential returns – especially after costs – is often overlooked. Take the recent clamour for gold as an alternative asset class. Predicated on the basis that gold acts as a monetary asset, is a hedge against inflation or, in some camps, will see significant demand growth as consumers in India and China seek to purchase more jewellery, the price of bullion has been driven from $250/oz back in 1999 to more than $600/oz at the moment.

Taking each of the arguments in turn, the reason gold was once used as a monetary asset was on account of its ease of mobility, together with its key attribute of being virtually indestructible. Since gold cannot be destroyed, every singleounce ever mined still exists in some form or other above ground today, and could be easily brought back to the market via the smelting process.

As an inflation hedge, the evidence is sketchy. As an asset that fails to deliver an income stream, all returns from gold come in the form of capital appreciation. Annualised returns over the past 25 years, even following the recent boom, have been only 1.3%, which is significantly short of the 3.2% growth in America’s Consumer Price Index over the same period. Figures for the past 20 years yield similar results.

Finally, take the Asian demand story, which seems to have been extrapolated from the justifiable case for increases in the price of oil. Figures from the World Gold Council show a 6.8% increase in demand for gold during 2005, which at first glance would seem to support the demand-driven growth story. But delve a bit deeper and it transpires that demand for gold for use in jewellery products rose by just 3.7%, with the big rise in demand (56.9%) coming from exchange-traded funds and similar investment vehicles – in other words, the investment industry. While demand may be increasing from the investment community, using this as an investment case is based around the “greater fool theory”, which has caused many a shattered investment dream in the past.

Putting the final nail in the golden coffin is the picture of potential supply. While annual demand for gold reached 3,700 tonnes during 2005, there is, within official banking reserves, more than 30,000 tonnes of gold gathering dust in vaults. With countries such as America, Germany, France, Italy and Japan all being the major holders of gold, and currently operating with significant budget deficits, the temptation to cash in on the golden windfall may prove just a bit too much.

Alternative assets can provide diversification benefits to investors and should be embraced as such, but to justify their position in an investment portfolio they must also possess a standalone investment case and give investors access to a cost-effective vehicle with which to gain access. Diversification alone simply will not wash.