Diversification or Diworsification?
During the financial crisis one mangled term to gain widespread use was “diworsification,” the counterintuitive idea that carrying all your investment eggs in one basket might be a better idea than old-fashioned diversification. In recent years, tactical asset allocation and trading out of trouble seemed to protect capital better than traditional approaches. One recent study even suggested that concentrated portfolios may be completely rational for those investors with little financial wealth relative to income.
In contrast, during other investment eras some investors have actively managed portfolios with as many as a thousand constituents, in other words grossly over-diversified. For example Peter Lynch, an acclaimed Fidelity fund manager, was successful in running an expansive portfolio of outperforming large and smaller companies.
A primary duty of the fund industry, along all of its often complex chains of intermediaries, is to professionally execute choices to allocate investor capital between competing investments and ensure a good risk/reward trade-off for the investor, whatever market conditions might prevail. These choices traditionally begin at a client level by identifying client characteristics, objectives, and risk tolerances to better inform decisions. According to one recent study decision makers should take also careful account of human capital and behavioral biases.
At an asset allocation level, the challenge is usually to first consider strategic and tactical allocations, weigh assets between asset classes, set the allocation of domestic versus international, and determine the split between passive versus various more active techniques.
At a portfolio level, choices lie between particular security groups and within individual securities. Still helpful in evaluating all these choices is Harry Markowitz’s famous explanation of the advantages of portfolio diversification, or modern portfolio theory, which manages risk using empirically derived historic means, standard deviations and correlations, or in Markowitz’s terms, the process of mean-variance optimization.
In the financial crisis, as equities collapsed and bonds seemingly offered little upside, some asset allocators became intolerant of inflexible strategic asset allocations that did not seem to work at that moment in time. The development of a plethora of novel alternative asset classes and techniques may have hindered rather than helped asset allocators by offering additional and often untested choices which many institutions lacked the proper resources to evaluate and which had immature advisory infrastructures.
The good news is that portfolio optimization is now evolving. For example, Thomas M. Idzorek, CFA speaking at a recent CFA Institute conference, argued in favor of incorporating the higher moments of skewness and kurtosis, which are highly appropriate to increasingly popular alternative investments. According to Sébastien Page, CFA, speaking at another recent CFA Institute conference, asset allocation is developing to encompass forecasts driven by macroeconomics and risk factor diversification. In factor investing, assets are viewed as bundles of underlying risk factors which are used as the basis of diversification rather than using fixed definitions of equities and bond asset classes.
In one recent study about factor investing, Richard Roll from the University of California at Los Angeles argues that traditional correlation measures obscure true factor exposures across and within portfolios and should be de-emphasized. In another new study, a trio of authors suggest that the use of a dynamic asset class weighting framework based on fluctuating market liquidity conditions can enhance portfolio performance. Whether asset allocators are choosing traditional or alternative assets for their investors, the list of helpful and innovative tools and techniques seem to be a fast growing one.
These recent CFA Digest summaries and related resources of interest to readers are summarized below:
- Why Does Junior Put All His Eggs in One Basket? A Potential Rational Explanation for Holding Concentrated Portfolios: Investors who have little financial wealth relative to labor income may rationally limit the number of assets in their portfolio when faced with such constraints as margin requirements and borrowing restrictions. The authors propose that the ratio of financial wealth to labor income is a viable control variable when studying the composition of household portfolios.
- Human Capital and Behavioral Biases: Why Investors Don’t Diversify Enough: The existence of human capital and its importance for investment decisions is well-known, but explicitly accounting for it is uncommon, and this failure can have devastating consequences. The failure to take human capital into account when making investment decisions can be explained by a variety of emotional and cognitive biases.
- Evaluating New Methodologies in Asset and Risk Allocation: Risk parity strategies favor bonds over equities, but they do not necessarily outperform a static portfolio of 60% equity/40% bonds. Portfolio optimization is evolving beyond traditional Markowitz mean–variance optimization to incorporate the higher moments of skewness and kurtosis, which are applicable to alternative investments.
- The Skew Risk Premium in the Equity Index Market: Using a dynamically hedged trading strategy, the authors are able to develop a new method for measuring risk premiums by attributing them to the risks exposed in specific moments of the distribution—namely, skew and variance. They demonstrate that the two premiums are related and that the variance premium trade strategy is potentially profitable. The skew strategy is not profitable when the variance strategy is hedged away.
- Risk Management beyond Asset Class Diversification: Asset allocation is evolving into an approach based on forecasts driven by macroeconomics and risk factor diversification. The dynamic nature of markets requires both secular and cyclical investment horizons. In addition, investors should look beyond volatility as a measure of risk and explicitly estimate the risk of tail events.
- Volatility, Correlation, and Diversification in a Multi-Factor World: Traditional correlation measures obscure true factor exposures across and within portfolios. By estimating factors that drive returns and selecting nonoverlapping investments that encompass each factor, managers can attain better diversification. The author presents a conceptual argument around the idea that standard correlation measures leave out important data regarding factor exposures. Because the latter ultimately drive portfolio returns, de-emphasizing traditional correlation and focusing instead on factor exposures allows a portfolio manager to diversify more effectively. The author presents several ways to estimate factors before identifying targeted exchange-traded funds (ETFs) as the most likely practical solution for investors.
- Factor Investing: In a summary of a chapter of a larger research work, Andrew Ang finds that in factor investing, assets are viewed as bundles of underlying risk factors. Investors should hold factors whose losses they can endure more easily than the typical investor can. Ideally, the benchmark for factor investing is dynamically based on investor-specific circumstances rather than on market capitalization.
- Liquidity-Driven Dynamic Asset Allocation: The use of a dynamic asset class weighting portfolio framework based on changing market liquidity conditions enhances portfolio performance. By adjusting asset allocations based on market liquidity premium environments, portfolio returns improve because higher risk asset allocations can be used in up markets and lower risk asset allocations can be used in down markets.
- Exploring Uncharted Territories of the Hedge Fund Industry: Empirical Characteristics of Mega Hedge Fund Firms: It is virtually impossible to obtain accurate historical data on the entire universe of hedge funds. The authors identify previously unexplored data sources that allow them to gain insight into the performance of hard-to-observe hedge fund companies that do not participate in major commercial databases.
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