16

Opinion
01: Scott Barlow

www.financialstandard.com.au 8 October 2012 | Volume 10 Number 19

principal, Risk Targeting Info

The Diversification Illusion

Contrary to the popular opinion of many investors and wealth management professionals, a portfolio constructed with a split between growth and defensive assets isn't necessarily adequately diversified, writes Scott Barlow01, principal of Risk Targeting Info. The quote

iversification has its roots in the princiD ples of Modern Portfolio Theory (MPT). Nobel Prize winner, Harry Markowitz, developed MPT in the early 1950s. His principles were simple to understand and striking by their implications: diversification can eliminate the risks that dont provide returns, while retaining the risks that do provide returns. Markowitz had very strong feelings about the benefits of diversification but he was also very clear about one other thing: diversification in a portfolio applies to risks, not assets.

Planners should be more concerned with how much of their clients wealth is at risk, not what asset classes they are risking their wealth in.

SOURCE: Investment Science Asset Management

investors become disillusioned when their balanced investments lurch deeply into negative territory and their defensive investments provide no defence at all. We know not to put all our eggs in one basket and financial planners tell their clients the first rule of portfolio management is diversification, yet the dominant portfolio construction approach in Australia, used by 99% of financial planners (strategic asset allocation) conceals the true risks behind asset class labels, leading to a concentration of risks in investor portfolios.

Additional risks are uncorrelated

The accepted adage is that to generate higher returns, investors must be willing to accept more risk. But Markowitz would have been quick to point out that it is equally important to ensure the additional risks do not correlate to the risks already in the portfolio. This does not appear to be the case in the portfolios of average Australians because for most ordinary superannuation savers, their climb up the efficient frontier (e.g from Conservative to Growth) usually just means acquiring more equities risk. If Trustees removed the strategic asset allo Conservative Balanced

SOURCE: Investment Science Asset Management

The Diversification Illusion

The chart to the right is a typical strategic asset allocation (SAA); a Balanced portfolio comprised of a mix of assets familiar to most ordinary superannuation investors. Described by its asset class weights, this portfolio appears well-diversified. However when we convert the asset class weights to risk weights (chart below), we see that equities risk accounts for around 95% of the total risk in the portfolio. This portfolio may be diversified by its asset class labels, but in terms of risks it is in fact highly concentrated and not well diversified at all. This is the diversification illusion and with these portfolios dominating the Australian financial planning landscape it is little wonder

cation constraint that says the manager must maintain fixed allocations to pre-nominated buckets (e.g. traditional asset classes such as shares, bonds, listed property etc), portfolio managers would then be free to bias their investment selection to a much wider range of investment opportunities. Free from the requirement to maintain the risk of the portfolio to an asset class constraint, the manager could avoid retaining exposures to over-priced or out of favour sectors or assets whilst remaining able to take advantage of oneoff value adding opportunities and to position the portfolio in accordance with prevailing valuation levels. The primary importance for persons saving for their retirement is whether they are on track to achieve their saving and post-retirement goals. Yet the portfolios of ordinary Australian superannuation savers are poorly diversified and constructed with reference to arbitrary benchmarks that have no obvious relevance to the investors goals. Investors are learning that they should be much more concerned with how much damage can occur to their wealth rather than what their portfolio is comprised of. For planners, this means they should be more concerned with how much of their clients wealth is at risk, not what asset classes they are risking their wealth in. If trustees moved to evolve the asset allocation paradigm by ignoring the traditional benchmarking constraints, it would free portfolio managers to utilise an extended list of asset classes, instruments and manager strategies. The improved diversification benefits, indeed a focus on prioritising the diversification benefits, would lift portfolio returns with no appreciable increase in total portfolio risk. Skilled managers (just those slightly better than average) would be able to deliver value in excess of the retail fee hurdle charged to investors and advisers would escape the clutches of the negative net value-adding investment proposition that is an entrenched feature of the financial planning industry. fs
Growth High Growth

Australian Shares Intl Shares Listed Property Fixed Interest Cash

15% 10% 10% 50%

35% 20% 15% 25%

45% 25% 15% 10%

60% 30% 5% 0%

15% 5%

5% 5%