Asset Portfolio Diversification vs Strategy Portfolio Diversification

Portfolio Diversification, one of the first things you learn in any financial 101 class. You hear it from the media, your broker may say it, your financial adviser says it, and even maybe your parents say it.

It is often that this phrase is thrown around, and has been taken for granted over the past few decades. That is until 2008; the year that no asset class was safe from the ongoing “crisis.” Typically, with my limited understanding, since I am no finance student, the phrase is generally meant to hold different kinds of “asset classes” in one’s portfolio to eliminate the risk of loosing everything at once if the portfolio performs poorly. It is even preferred to have uncorrelated asset classes strengthening against diversification risk (if possible).

Though, I would assume, in a typical 401k or some form of a nest egg, the average middle class American would hold typical vanilla products (i.e. some mix of stocks, bonds, or money market products) and call it diversification.

Perhaps in the “pre-crisis” era, this form of “diversification” was acceptable, though in a globalizing world this may not be the case any more. (Bear with me while I try to make a point) Those who would like to argue a decoupling theory, I simply point to an event such as 2008, point and case. If those who are still adamant and wish to cite the recent performance of Asian markets, I will point out that the majority of emerging markets are far from being fully developed in order for capital flows to significantly diminish any affect of trade flows. Even if the currently focused emerging markets were able to fully industrialize in the next decade (which is impossible), you still have all of Africa that could occupy the developed nations for well over a few decades. From an economic perspective, necessary natural resources will always have a close intimate relationship with trade flows in a scarce world. This is one perspective I can certainly agree with from a neo-classical perspective.

The point being, diversification is not as simple as investing emerging markets or simply buying bonds vs. stocks. Simply put, asset diversification may become a thing of the past as the financial landscape is being remodeled in this current day.

I’m well aware that there is a huge amount of literature on this subject, though I wish to make a point whether this is a well covered topic or not. As hedge funds are making their supposed recovery, a new breed of fund managers are emerging. In addition, we are seeing new asset classes being formed every day, such as hedge fund ETF oriented strategies. Even traditional mutual fund managers such as Charles Schwab are broadening investment vehicles to their clients. Further more, often I hear chatter from ibankers about future changes to front office models.

Along with all these changes in the landscape, the type of diversification will need to change as well. As I hinted from above, perhaps it is not the asset class that matters, but it is the strategy and philosophy of different funds and financial institutions that will make up the fabric of portfolio diversification. As opposed to picking the assets that are uncorrelated, it maybe more important to solely focus more on a type of strategy a fund employs.

One may think that if this is the future scenario, hedge funds are best suited to profit from such an opportunity. I will argue that this may not be the case, as again, 2008 showed that hedge funds were just as vulnerable as any other institution (be it for sentiment or fundamental reasons). Hedge funds, more so larger hedge funds, will be more exposed to a lack of portfolio diversification as they are often invested in wide array of asset classes. Even with uncorrelated assets in their portfolio, another disaster could produce similar results as seen in 2008.

Arguably, it maybe the smaller specialized hedge funds or boutique funds that can benefit from a downturn. Given the right strategy and discipline of a boutique fund, performance can be positive even in the worse case scenarios. Asset class exposure risk is limited as boutique funds will specialize in their niche market, and will rely more on their strategy and be more focused to produce returns. In larger funds, there is an inherent risk of managing many different asset classes as they all require different forms of analysis, risk evaluation, method and approaches, and subject to different taxes and regulation. This is extremely costly in terms of time and capital to maintain positions across many asset classes. The larger the fund gets the larger the risks gets. The risk of managing varying asset classes diminishes if you are a specialized boutique firm. However, I will point out that the larger funds that have survived the 2008 crisis, mainly have survived due to a good disciplined strategy, which was strong enough to out weigh asset class risks. Overall though, performance suffered due to higher exposure over many asset classes.

Though, I do say strategy may be more important for future portfolio diversification, since two different funds invested in the same asset class can produce varying returns, I do realize that assets are still important since they may generally correlate. An inherent risk in this model is if copy-effects take place in a large number of boutique fund participants, leading to similar sentiment led environments we have today that are reminiscent of expectation-driven models.

It would be important to stress that fund strategy be unique enough to produce desired diversification results. It is in this context that we may extrapolate that Hedge fund of Fund models (HFoF) maybe best suited to benefit from strategy oriented portfolio diversification. Perhaps this may lead to a new model of Funds of Boutique Funds, which allow for investors to gain exposure to unique varying fund strategies that are specialized in whatever asset class or market sector.

Whether or not this idea is in the currently literature or not, I feel it is important to emphasize or re-emphasize as change comes about. As investors look for new avenues to invest, diversifying ones portfolio by strategy is well worth considering in order to avoid such herding disasters as seen in 2008.

Lastly, many of these developments of course depend on the rapid current regulation and compliance changes we are seeing through out the world. Are policy markers competent enough to produce the necessary regulations to facilitate healthy market growth and boost investor confidence, or will they choke innovation that may lead to financial stagnation? For certain, I am hoping for the latter scenario which may lead to new innovations as discussed above.

-Alexander Lê of Group ANLZ