Managing risk through diversification: Understanding the complexities

Diversification is an age-old risk management practice in which investors reduce their exposure to negative events by placing their wealth in different assets. However, it is not always easy to get right, even for those with experience and understanding,

Bekker clarifies that from an asset class perspective, diversification is the allocation of wealth across different asset classes such as equity, cash, bonds, money market private equity etc. “Diversification across asset classes is a risk management tool that is used when markets are behaving normally,. As a general rule, during periods of high growth, investors would want more exposure to aggressive asset classes such as equity, which traditionally outperform in rising or bull markets. Defensive asset classes such as bonds and cash generally underperform equity during rising markets, so investors would want a lower exposure to them during these times.

“It works in the opposite way during periods of low growth or negative markets (bear markets), when investors would want less exposure to aggressive asset classes such as equity, and a higher exposure to defensive asset classes such as bonds and cash. Of course, the difficult part from an asset allocation perspective is to position the portfolio – otherwise known as market timing - before the bull or bear markets occur, but this is extremely difficult for asset managers to get right on a consistent basis.”

Bekker cautions that during extreme events that occur in investment markets, for example the credit crisis in 2008, a phenomenon called autocorrelation can occur, in which asset classes that were historically uncorrelated or had low correlation, start behaving in the same way.

“This means that at the very time when diversification is most needed, in other words extreme economic or market events, the strategy that was supposed to protect investors, in other words low correlation across asset classes, no longer applies. Again, this means that the ability of a manager to add outperformance or protection against downside losses is an extremely difficult skill set, especially on a consistent basis.”

Bekker says that from a stock selection perspective, diversification across industries and sectors can be an extremely useful risk management tool for portfolio managers.

“The ability of managers to invest in certain companies but to diversify the industry and sector within which the companies operate, means that a manager can gain the outperformance of the equity markets during bull markets while at the same time offering some form of risk protection against industry headwinds,” he says.

“For example, the resource sector is experiencing considerable challenges at the moment but the industrial and financial sectors are faring better. A manager can therefore still potentially gain the outperformance offered by the equity markets by investing in industrials and financials companies while staying away from mining companies. Unfortunately the sector and industry diversification benefits also get negated by autocorrelation during extreme events but it still offers managers some form of protection against drawdowns and capital losses.”

Bekker adds that diversification can also be achieved through exposure to different currencies. “The advantage of this is that currency movement can often negate any return on underlying investments, no matter how good the stock selection and asset allocation decisions were by the manager. Also, currency movements can also provide additional alpha (performance) even if the stock selection and asset allocation decisions underperformed. For example the recent depreciation of the rand against the US dollar means that those domestic managers that had a big offshore allocation denominated in dollars would have achieved an additional 15%+ on their investments purely on the exchange rate movements.”

Bekker concludes by saying that although diversification is a key tool for a fund manager’s risk management, it is not easy to achieve as there are diversification benefits and costs across asset classes, sectors, industries and stocks as well as through currency movements. “These all need to be considered individually and as a whole to be successful. Managers also need to be cognisant of the autocorrelation phenomena, which negates the benefits of diversification during extreme events when they are needed most.”