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Diversification is a free lunch, but you get what you pay for

Diversification is one of the most effective tools an investor can use, for the simple reason that spreading risk means you are unlikely to get wiped out if one or two investments go bust. But it is not a foolproof concept, and in fact it is laden with potential traps.
Opinion

Famously described by Nobel Prize winner Harry Markowitz as the only “free lunch” in investing, diversification can help investors maximise return for a given level of risk or, viewed another way, minimise risk for a given level of return.

Most advised investors hold portfolios that are broadly diversified across asset classes such as shares, fixed interest, real estate – some listed, some direct – and cash, and diversified geographically as well. Advisers tend to confine diversification to the broad asset classes, seeking to take advantage of the correlations – or, hopefully, the lack thereof – among the asset classes.

That’s the basis of Markowitz’s theory: that if the different asset classes (or different securities) in a portfolio are not positively correlated, then when one performs poorly, other parts of the portfolio offset this by doing well.

  • The problem is that correlations among asset classes are not set in stone and cannot be relied upon.

    The most obvious example is the bonds/equities noncorrelation, the bedrock of the ’60/40′ balanced portfolio. For almost 40 years, the 60 per cent/40 per cent portfolio mix of stocks and bonds has weathered virtually all market conditions to both deliver reliable returns to investors and reduce overall portfolio volatility. It worked until 2021-22, when historically low bond yields, trending toward zero, saw bonds fall by even more than shares.

    With bonds and equities down at the same time, there has been no place to hide.

    Super funds and other institutional investors have looked elsewhere for diversification, dumping bonds for asset classes such as credit, infrastructure, private equity and debt, and even macro hedge funds and trend-following strategies.

    While bonds have started to recover, the 60/40 portfolio is still nowhere near ‘back in town’.

    Individual investors have been flooded with opportunities for diversification in recent years, with the explosion of exchange-traded funds (ETFs) enabling them to ‘buy’ a wide variety of asset classes – from international shares to US high-yield credit – through one purchase on the ASX, of a stock that is tradeable at any time, and into which any amount can be invested. The ETF revolution has unquestionably allowed retail portfolios to improve their diversification – although diversifying into a bond ETF will not have worked over the last 12 months – but it also raises a few other issues with diversification that have to be watched. 

    For example, index concentration can heavily skew ETF investments.

    If you buy an ETF covering the S&P/ASX 200, such as State Street’s SPDR ASX200 ETF, you will be heavily exposed to the big four banks – ANZ, Westpac, Commonwealth Bank and National Australia Bank – plus global investment bank Macquarie (together making up one-quarter of your investment), plus two big resources companies: BHP and Woodside Energy (13.1 per cent of your investment).

    Your investment in resources and banking thus comprises close to 40 per cent of your exposure – which is not ideal if there is a problem in one of those industries, or in the perception of those industries on the part of investors. Which certainly can happen!

    This can be exacerbated if the unwitting investor holds shares in these companies directly, which many do on yield grounds.

    Looking for yield might lead you to put together a portfolio that contains three of the big four banks and also includes BHP, Rio Tinto and Fortescue, to take advantage the very attractive fully franked yields on offer courtesy of high commodity prices and healthy margins on the part of these miners. But you have ended up with a poorly diversified portfolio.

    Perversely, the same thing can come about through over-diversification, where the investor gets overly excited about the sheer range of investments available and takes positions in assets without really understanding the asset or the forces that drive it. This ‘diworsification’ can lead to an unnecessarily complicated portfolio and possible losses.

    Another problem is that different ETFs can hold overlapping securities, causing you to unwittingly heighten your concentration.

    A solution to this problem – which we do not yet have in Australia – is duplication-finding tools such as Morningstar’s Portfolio X-Ray tool. If an investor enters the names of each fund or individual security in a portfolio to this tool, it adds up duplicate exposures to individual securities, showing hidden concentrations.

    Duplicated investments – and the possible negation of the diversification that the investor expected – can also be a problem in actively managed funds. Time and again, managers of Australian broad-based equity funds are revealed as closet index-huggers, holding portfolios similar to their benchmark – and, by definition, not really earning their active-management fee.

    In this case, the adviser should be able to gain access to each manager’s ‘active share’ figure, a measure of the percentage of shareholdings in a manager’s portfolio that differ from the benchmark index. Managers with a high active share – you certainly want to see it above 60-70 per cent – are earning their fees, and you are also benefiting from the fact that the active-share measure has been shown to be a good predictor of fund performance. Good advisers know how to isolate performance and ‘blend’ investments such that a diversified approach is working the best that it can.




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