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Diversification in thinking and practice

In 2015, Brookvine ran a workshop modestly entitled ‘WhiteBoarding 2.0’ where advisors and Chief Investment Officers to High Net Worth (HNW) clients and Family Offices (FO) assessed the role of diversification in their thinking and practice.

The wisdom of diversifying is ancient: Warren Buffett has stated that it’s a hedge against ignorance and a modern version of the biblical instruction to ‘divide investments among many places, for you know not what risks might lie ahead’. A millennium later, the Talmud offered an explicit and not unreasonable uniform diversification, to divide equally across ‘buying and selling things’ (equity), ‘gold coins’ (cash) and ‘land’ (real estate).

Selling diversification to HNWs

Until Modern Portfolio Theory (MPT) came along, diversification was justified by the slogan ‘don’t put all your eggs in one basket’ as opposed to the less common but for some equally valid, ‘put all your eggs in one basket but watch it very carefully.’ By quantifying risk, Nobel Prize winner Harry Markowitz transformed diversification from a slogan to an explanatory and operational tool. Diversification went from theoretical insight to black letter law in a mere 20 years and became an investment truism, the ‘single most important thing’ in portfolio construction. Superannuation funds must ‘have regard to’ diversification and for MySuper funds, it is compulsory. Yet many private wealth portfolios and SMSFs are less than ‘optimally’ diversified … often for sound reasons.

Most wealth is created by HNWs through direct investment in a single business. That makes it hard for wealth creators to appreciate the logic of diversification in their investment portfolios as they transition from getting-rich to staying-rich. Sensitive advocacy is needed to convince HNW families of the efficacy of diversification in preserving capital, especially in explaining the need for unconventional asset classes such as private real estate lending, catastrophe bonds, real assets like agriculture and timber, infrastructure, oil/gas, and collectibles including art that are unfamiliar and hard to access. Advocacy can be re-enforced through ‘diversification’ of a different type in which portfolios are structured around different purposeful ‘themes’ such as income, aspirational/opportunistic, security, legacy/philanthropic, and fun/trading.

Whether diversification is a free lunch led to vigorous discussion among participants at the workshop. Forceful comments were made on the cost and risk of ‘diworseifying’, a consequence of agents minimising business risk, consistent with Berkshire Hathaway’s Charlie Munger’s statement that “diversification is a veil to hide behind”. A more direct cost flows from the added complexity of more asset classes demanding more advisor time, thus making fees an issue. Costs led to an engaging debate around the perceived recent failure of diversification exacerbated by the one-way path in asset prices clients have experienced for almost a generation. Some advisors saw a consequent need for more dynamic approaches to diversification.

Two brothers with different goals

A case study involved two brothers who were distinctly different investor types with different goals and objectives. Because decisions have financial as well as emotional or psychological dimensions, advisors need to appreciate families’ experiences, expectations and idiosyncrasies lest diversification remain an abstract notion. These include:

  • any relevant friction within families
  • what they most worry about
  • the time horizon they think in terms of
  • the level of control they want
  • any roles they want to play in decision-making
  • their biases and strength of their convictions
  • the extent to which unrealised taxable gains are an impediment to change
  • their personality types
  • how they think about and describe risk
  • any comparative advantages the trusts have.

These can be partly expressed in a ‘family governance document’ that can help link investment strategies to financial and emotional well-being.

Klyde, an entrepreneurial businessman who created his wealth by building a narrowly focused business, established a trust for the benefit of his immediate family and future generations. He struggles to relinquish control, making the trust’s implicit purpose somewhat ambiguous and therefore a challenge for an advisor wedded to the tenets of MPT. His brother, Cerry, a delegator with minimal interest in investing, established a perpetual philanthropic trust to support the arts with an explicit objective: spend 5% per annum to maintain its tax-free status.

Klyde had tried to diversify his businesses with disastrous results, an evident source of resistance to portfolio diversification. His trust’s initial configuration, dominated by the idiosyncratic risk of a single business, was seen as dangerously under-diversified, exposed to a meaningful risk of a sizeable capital loss that could be materially reduced through diversification. Advisors favoured slowly but tax-effectively reducing the weight of legacy assets and crafting a portfolio with more calculated bets, and direct ownership of some other assets. They recognised cash as a very active component of the portfolio and favoured a program of sizeable shifts in allocations.

Alternative investment models: entrepreneurial and transitional

The entrepreneurial model favours a concentrated set of investments familiar to Klyde, combined with interests in operating businesses aligned to his experience a bias away from co-mingled funds. This model needs to be managed by an in-house team supplemented by external advisors. The initial lack of diversity may be partly compensated for by its unique deal-flow advantages.

The transitional model reduced the weight of the legacy business and favoured a far higher weight to non-operating assets with a more conventional notion of diversification through a planned transition to a broader array of assets. This model is more accepting of co-mingled funds, and of public markets and alternative assets. Nonetheless, it is avowedly opportunistic and ready to work with Klyde in vetting opportunities originated through his networks. It demands more sophisticated external advice for origination, due diligence and monitoring.

Cerry’s philanthropic trust was less problematic. Its purpose is explicit and tax plays a marginal role, while on the psychological side Cerry is unlikely to argue for greater concentration or control. Advisors saw the initial configuration, dominated by Australian real-estate, as dangerously under-diversified, exposed to a meaningful risk of a sizeable capital loss which could be materially reduced through sales, with the proceeds directed towards diversification. Cerry’s trust also has paintings: legacy assets where he has a strong emotional attachment. Such collectibles can play a powerful diversifying role.

For Cerry, a third outsourced model was preferred where management is primarily delegated to an investment advisor with a portfolio that blends traditional public markets with a heavy mix of alternative assets. Benchmarks and tracking error were, by institutional standards, irrelevant because, being perpetual, the trust should have considerable tolerance for short-term variability and should favour long-duration and particularly real assets such as infrastructure and timber.

Conclusion

WB2.0 re-enforced the view that diversification is an effective way of reducing risk of capital loss and of lowering volatility. It is almost a free lunch. For large institutional funds it should be weakened only under justifiable circumstances. For smaller Australian private wealth funds its full benefits are harder to achieve due to tax, liquidity needs, access to unfamiliar assets and the technical nature of arguments. It is difficult for advisors to convince clients of the need for some diversification given the concentrated approach founders relied on to accumulate wealth and their strong emotional attachment to their businesses.

WB2.0 did show that the nuances of diversification are not fully understood. Its value will be questioned again if the next crisis sees all assets go down together. Nonetheless, thinking and practice have evolved. Advisors are seeking unconventional assets that offer stronger diversification benefits; they are questioning the ‘optimal’ level and type of diversification, thinking about diversifying across risk factors and exploring more dynamic approaches to asset allocation. As one participant wisely observed, “diversification is harder to deliver, but the results are better and you have happier clients.”

 

Jack Gray is a Director and Advisor, and Steve Hall is the Chief Executive Officer of investment manager and advisor Brookvine. Whiteboarding 1.0 and 2.0 are available on request via www.brookvine.com.au. Jack has been voted one of the Top 10 most influential academics in the world for institutional investing.

 

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