By Euan MacLaren
In building an institutional portfolio, investors tend to focus on the end game – prioritising returns over risk. But taking this approach can cause issues, as many assets selected for return purposes are in fact highly correlated with one another.
A more effective approach is to prioritise risk and maximise diversification, in order to construct a portfolio that will withstand market shocks and ensure it can meet its liabilities over the long-term. However, diversification isn’t necessarily as simple as it seems.
Markets have evolved over the years, presenting investors with a range of on-going challenges. The recent volatility which ensued following concerns around the Chinese stock market is a perfect illustration of this, and investors with insufficiently diversified portfolios are now enduring a deeply unpleasant few weeks.
But a great challenge to diversification is that investors think they know how their portfolios are positioned, when in reality they look quite different; this is particularly true on the asset side. Investors are unknowingly being exposed to hidden correlations – resulting in their supposed diversification strategy leaving them not as diversified as they first thought. This can present itself in a number of ways.
It has become increasingly difficult to find income-generating assets in the last few years, which leaves institutions with a problem. They can produce portfolios that seem diverse, with many funds included within them, but this seeming diversity may give investors a false sense of security if the assets within each fund have a high correlation in terms of performance.
Our own research has found, many portfolios holding multiple strategic income funds from different managers. However, a large number of these types of funds are very highly correlated with one another, thereby increasing the overall level of risk in the portfolio instead of diversifying it. Hence the illusion of diversity.
With active management being the hot topic of the moment, institutions may sometimes forget that active management alone doesn’t add value to a portfolio, but instead you must also have a selection of strategies that complement each other – and don’t all just invest in the same big names under the guise of different investment styles. Investments should not only focus on specific products alone, but should also address the underlying factors effecting, or due to effect, them thus creating a strategy that aims to deliver risk-adjusted returns through market cycles.
This doesn’t just apply to flexible funds however; rising correlations among all types of fixed income investments are causing headaches for investors already struggling to find yield from this asset class. Sometimes the majority of fixed income products chosen have similar characteristics and correlations, such as corporate and high yield bonds, making it difficult for institutions to escape high correlations even across seemingly different fixed income categories.
Ultimately there’s no one-size-fits-all solution to ensure institutional investors are sufficiently diversified, however understanding that diversification is a crucial element of portfolio construction in order to reduce overall risk is half of the battle. The key then for investors is to closely examine all funds within their portfolio, to ensure whether they are sufficiently different from one another in terms of correlations.
Euan MacLaren is head of UK & Ireland institutional business, Natixis Global Asset Management
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