Register For Our Mailing List

Register to receive our free weekly newsletter including editorials.

Home / 194

Portfolio diversification: when a free lunch can cause indigestion

Diversifying investment portfolios is known to provide a rare ‘free lunch’ to investors. The value of portfolio diversification was demonstrated by Harry Markowitz, who also gave investment professionals one of their most beloved acronyms, ‘MPT’, when he established Modern Portfolio Theory in 1952. MPT demonstrates how diversification removes unrewarded risks in a portfolio without sacrificing return expectations.

Measuring risk factors

How effectively diversified a portfolio is can be measured a number of ways. Simple ways cover the number and variety of assets, managers, sectors and industries in the portfolio. More sophisticated measures capture how correlated the portfolio’s assets are to each other (how closely their values move up and down together) and how much the performance of these assets can be explained by underlying common ‘factor risks’.

Factor risks are attributes like size, value (for example, low price to book value), growth, momentum and volatility. A diversified portfolio spreads exposures across a range of factor risks, rather than loading up on one or two factor bets. Of course, an investor deliberately loading up on assets with particular-factor attributes (such as value stocks) is not necessarily being unwise. But the investor must recognise that this becomes more like a high-conviction, concentrated portfolio than a well-diversified one.

Portfolio diversification has benefitted investors since the advent of MPT, especially for large investors with billion-dollar portfolios at stake. However, there is a kind of ‘indigestion’ to this free lunch which we uncovered last year while analysing the Australian equity portfolio of one such large superannuation fund.

Superficially, the portfolio showed the qualities of a well-diversified equity portfolio, which was the objective of the fund:

  • 11 discrete managers and styles
  • 538 holdings of ASX-listed stocks
  • a spread of between 20-88 ASX-listed stocks per manager
  • exposures to five of the factor risks (size, value, growth, momentum and volatility).

Putting the jigsaw together

However, we discovered that this diversification was working against the fund in three critical areas.

First, it was hard for the fund to think about and analyse the portfolio as a whole. The complete picture could only be assembled by putting together the jigsaw of separately managed portfolio pieces. We did this by reconstructing the multi-manager portfolio in a centralised portfolio management (CPM) structure.

Second, we created a measure of ‘portfolio redundancy’, or the extent to which the 11 managers were holding very similar positions. We measured portfolio redundancy by calculating, per manager portfolio, the minimum of each stock’s value held in both the specific manager’s portfolio and the wider portfolio (ex-manager) – overlapping stock positions – and then summing these per-manager overlap figures on a weighted basis (reflecting manager weights within the total portfolio) as follows:

Too many similarities diminish diversification

Our portfolio redundancy calculation of 42.2% showed that the 11 managers were creating similar positions to each other over nearly half of the portfolio by value, or 452 of the total 538 stocks. Only 57.8% of the portfolio, across 86 stocks, was doing the heavy lifting to diversify the portfolio away from this common core.

This problem can arise in multi-manager portfolios which benchmark the underlying managers to similar indexes such as the S&P/ASX 300. ‘Tracking error’ to benchmark is a form of risk which these managers will not take on unless they expect to be rewarded. A large investor may think it is diversifying by spreading its portfolio over a number of managers, but if all the manager portfolios are tightly tracking a similar benchmark, there can be less diversification, and more portfolio redundancy, than the investor thinks.

Third, we classed each stock holding as a type of factor risk exposure to consider the level of factor risk diversification at the whole-of-portfolio level. Each of the 11 manager portfolios was expressed as a bundle of factor risks to detect how true to label each manager was (for example: was a value manager long the value factor? Was a defensive manager long the low volatility factor?). We identified two managers who were virtually identical to each other and another three who were very similar when profiled according to factor risks. Hence, three managers were adding nothing to the factor risk diversification of the portfolio.

False sense of security

This exercise shows how the free lunch of diversification can cause indigestion when it gives a false sense of security, complicating the portfolio and muddying the bigger picture, rather than reducing the risks of the portfolio.

There is another danger of using a wide suite of active managers with a seemingly diversified set of risks which can directly hit the investor’s bottom line. If the collective risks, from a whole-of-portfolio perspective, look just like the market, then the investor is paying active management fees for a portfolio that could have been provided much more cheaply by an index manager or ETF provider.

 

Raewyn Williams is Managing Director of Research at Parametric Australia, a US-based investment advisor. This information is intended for wholesale use only. Parametric is not a licensed tax agent or advisor in Australia and this does not represent tax advice. Additional information is available at www.parametricportfolio.com/au.

RELATED ARTICLES

Multi-manager diversification or tax efficiency or both?

Harry Markowitz's 'aha moment' in asset allocation

Why 2020 has been the year of the bond market

banner

Most viewed in recent weeks

Stop treating the family home as a retirement sacred cow

The way home ownership relates to retirement income is rated a 'D', as in Distortion, Decumulation and Denial. For many, their home is their largest asset but it's least likely to be used for retirement income.

Welcome to Firstlinks Edition 433 with weekend update

There’s this story about a group of US Air Force generals in World War II who try to figure out ways to protect fighter bombers (and their crew) by examining the location of bullet holes on returning planes. Mapping the location of these holes, the generals quickly come to the conclusion that the areas with the most holes should be prioritised for additional armour.

  • 11 November 2021

Welcome to Firstlinks Edition 431 with weekend update

House prices have risen at the fastest pace for 33 years, but what actually happened in 1988, and why is 2021 different? Here's a clue: the stockmarket crashed 50% between September and November 1987. Looking ahead, where did house prices head in the following years, 1989 to 1991?

  • 28 October 2021

Why has Australia slipped down the global super ranks?

Australia appears to be slipping from the pantheon of global superstar pension systems, with a recent report placing us sixth. A review of an earlier report, which had Australia in bronze position, points to some reasons why, and what might need to happen to regain our former glory.

How to help people with retirement spending decisions

Super funds will soon be required to offer retirement income strategies for members in decumulation. With uncertain returns, uncertain timelines, and different goals, it's possibly “the hardest, nastiest problem in finance".

Tips when taking large withdrawals from super

You want to take a lump sum from your super, but what's the best way? Should it come from you or your spouse, or the pension or accumulation account. There is a welcome flexibility to select the best outcome.

Latest Updates

Investment strategies

Charlie Munger and stock picks at the Sohn Conference

The Sohn Australia Conference brings together leading fund managers to chose their highest conviction stock in a 10-minute pitch. Here are their 2021 selections with Charlie Munger's wisdom as the star feature.

Interviews

John Woods on diversification using asset allocation

All fund managers now claim to take ESG factors into account, but a multi-asset ethical fund will look quite different from a mainstream fund. Faced with low fixed income returns, alternatives have a bigger role.

SMSF strategies

Don't believe the SMSF statistics on investment allocation

The ATO's data on SMSF asset allocation is as much as 27 months out-of-date and categories such as cash and global investments are reported incorrectly. We should question the motives of some who quote the numbers.

Investment strategies

Highlights of reader tips for young investors

In this second part on the reader responses with advice to younger people, we have selected a dozen highlights, but there are so many quality contributions that a full list of comments is also attached.

Investment strategies

Four climate themes offer investors the next big thing

Climate-related companies will experience exponential growth driven by consumer demand and government action. Investors who identify the right companies will benefit from four themes which will last decades.

Investment strategies

Inflation remains transitory due to strong long-term trends

There is momentum to stop calling inflation 'transitory' but this overlooks deep-seated trends. A longer-term view will see companies like ARB, Reece, Macquarie Telecom and CSL more valuable in a decade.

Infrastructure

Infrastructure and the road to recovery

Infrastructure assets experienced varying fortunes during the pandemic, from less travel at airports to strong activity in communications. On the road to recovery, what role does infrastructure play in a portfolio?

Economy

The three prices that everyone should worry about

Among the myriad of numbers that bombard us every day, three prices matter greatly to the world economy. Recent changes in these prices help to understand the potential for a global recovery and interest rates.

Sponsors

Alliances

© 2021 Morningstar, Inc. All rights reserved.

Disclaimer
The data, research and opinions provided here are for information purposes; are not an offer to buy or sell a security; and are not warranted to be correct, complete or accurate. Morningstar, its affiliates, and third-party content providers are not responsible for any investment decisions, damages or losses resulting from, or related to, the data and analyses or their use. Any general advice or ‘regulated financial advice’ under New Zealand law has been prepared by Morningstar Australasia Pty Ltd (ABN: 95 090 665 544, AFSL: 240892) and/or Morningstar Research Ltd, subsidiaries of Morningstar, Inc, without reference to your objectives, financial situation or needs. For more information refer to our Financial Services Guide (AU) and Financial Advice Provider Disclosure Statement (NZ). You should consider the advice in light of these matters and if applicable, the relevant Product Disclosure Statement before making any decision to invest. Past performance does not necessarily indicate a financial product’s future performance. To obtain advice tailored to your situation, contact a professional financial adviser. Articles are current as at date of publication.
This website contains information and opinions provided by third parties. Inclusion of this information does not necessarily represent Morningstar’s positions, strategies or opinions and should not be considered an endorsement by Morningstar.

Website Development by Master Publisher.