The theory of diversification is 60 years old but assessing funds for a portfolio has been like scouring the proverbial haystack. Now technology has made the needle much easier to find.
Modern Portfolio Theory has been a cornerstone of our industry ever since Harry Markowitz published his Nobel Prize winning work in the 1950’s. Its core principle of “portfolio diversification” however, is still poorly understood. The idea that a collection of investments that display high levels of risk individually can be low risk overall is intuitively a difficult notion to understand. While most people begrudgingly accept this concept at the highest level when considering asset allocation, they revert to an individualist view when choosing funds. This is depriving investors of the full benefits of diversification that were identified over 60 years ago.
Diversification harnesses the differences between investments and offsets their individual fluctuations against each other to smooth out the effect felt by the investor. For this approach to produce a noticeable impact, it is necessary to combine investments with as low a correlation to each other as possible. Consider two possible investments; one in the UK stockmarket, represented by the FTSE All-Share index, and one in UK government bonds, represented by the FTSE Actuaries UK Government All Stocks index. Individually one is considered high risk – high reward, and one is considered low risk – low reward. By combining these two investments it is possible to receive the returns from both but for much less risk. This can be seen in the first graph; although there has been little benefit of investing in equities at all over the last 15 years, the time period selected demonstrates the concept quite accurately.
This approach is understood at the asset allocation level. Asset classes such as equities, bonds, property and cash are chosen for the low correlation to each other. For a desired level of risk, different mixes of these asset classes are selected to offer the best possible expected returns. This is where diversification usually ends. Many advisers implement their strategic asset allocation by picking funds for each asset class. When assessing suitable funds for their portfolio, they usually look at them in isolation. Factors such as performance, volatility, the quality of the team, the track record of the manager are the mainstays; even professional analysts who strive to delve deeper into the viability of a strategy, or fund ratings still treat funds as separate entities and ignore their interaction with each other.
This is fine for identifying good funds, which is obviously an important part of portfolio construction, but it does not guarantee the best portfolio. Even once you have narrowed down your choices to the very best funds in each asset class, you are still faced with a choice of at least 100 funds and, for a 10-fund portfolio, that amounts to a staggering 17.3trn possible portfolio combinations. This number is greatly reduced once asset class restrictions are applied, but it demonstrates the unseen problem in portfolio construction. For every asset class it is possible to identify three or four outstanding fund choices; typically at this point the most minor of differences becomes the deciding factor, with personal preference playing no small part in the final decision.
On the face of it, this looks like a pretty good outcome. A portfolio containing a diverse mix of asset classes, populated with the best funds available sounds like a win in anyone’s book; but by ignoring the diversification effect between funds, huge improvements in the risk – reward profile have been forgone. Instead of looking at each fund individually, investors would reap vast benefits if they further leveraged the principle of diversification by studying how funds interact with each other.
Active funds do not mirror their underlying asset classes exactly. Differences in strategy, style, economic outlook, and even the moods of the fund managers, all combine to ensure that no two funds behave alike, and this can be used to our advantage. By analysing the relationship between funds, identifying where these differences offer a significant advantage, we are able to further diversify and lower the overall risk of the portfolio.
Imagine a moderately cautious investor who had identified the need for a 20 per cent exposure to UK equities. A likely outcome would be a cautiously minded, defensive fund, possibly in the UK Equity Income sector that offered access to the asset class but fit the risk profile of the investor. But a better solution exists. Within the spectrum of UK equity funds available that meet the required standard for excellence there will be a superior solution.
Assume there are two alternatives: a fund with an aggressively minded fund manager, with a bullish outlook on the economy and who believes in the growth prospects of the technology sector; and a fund that relies on pure stockpicking to identify undervalued companies and has a bias towards only the most stable and financially secure firms. These two funds invest in the same asset class but will behave differently, the conditions for one to excel are different to the optimal conditions for the other. The same principles of diversification apply; the combined returns are available for much less risk than average.
If we expand this principle across all asset classes, it is possible to use the active element of funds to add further diversification benefits and obtain the same asset class exposure for a much lower level of risk than expected. Alternatively, the same level of risk can be achieved while having greater exposure to risky, higher returning assets. An example of how this works in the real world is seen in the second graph: a portfolio following the same asset allocation strategy using active funds is able to have a much lower risk profile than the same strategy implemented with index tracking funds, over a six-month period.
This seems quite obvious, and most advisers will no doubt try and get a broad range of styles and characteristics when picking funds for a portfolio. The problem though is how to objectively assess which funds offer the very best mix and interaction. While it is possible to understand how two funds react quite easily, and even three funds, the multitude of interrelationships within a larger portfolio are far too many and complex.
The only way to truly maximise the diversification benefits within funds is to try and analyse every possible combination, and then select the mix that offers the greatest reduction in portfolio volatility relative to the volatility of the individual funds. This requires some considerable number crunching. Accessing the risk profiles of 17trn possible portfolios is a task that is beyond even the most avid excel user, and is the main reason diversification has traditionally stopped at the asset class level. To complete the task successfully you would need a database of fund information and past performance; the expertise to calculate and interpret volatility; the ability to create, store and analyse all the portfolios and the computing power to prevent this from taking several lifetimes.
Selecting the optimal portfolio from the near infinite range available is much like looking for a needle in a haystack. However, by modelling the characteristics of each portfolio, it is possible to create a range of portfolios that contain the optimal combination of funds at every level of risk. Developments by leading academics and fund research house FE, have made great strides in this area. Having the required technological infrastructure and quantity of fund data at their disposal, they have managed to perfect this process.
Even without software to maximise this effect, it can still be used to great advantage. Simply by including a standard correlation table in your usual fund analysis process allows you to spot funds with additional diversification benefits, even if fundamentally they appear the same. Reducing the risk of a portfolio is a fine aim by itself, but with inflation creeping up, producing a real return is becoming ever harder. Finding a way to include higher risk asset classes into cautious and balanced portfolios is likely to be one of the main challenges in portfolio construction in the future.
Diversification has been the driving force enhancing investors’ returns for over a generation, and now thanks to recent breakthroughs, is poised to offer more benefit than ever before. For too long funds have been viewed in isolation, merely as vehicles providing access to an asset class. The importance of viewing a portfolio as a whole, something that has been understood for over 60 years, is finally possible for the majority of investors – not just a few privileged institutions.
Rob Gleeson, is the head of research at FE