Time to concentrate? How investors are giving up on diversification

Diversification has long been a catch-word of the investment industry. Since the global financial  crisis however, many institutional  investors have begun to concentrate more,  not just in terms of how they spread their  assets,  but in spending more brainpower  analysing  their risk budgets and increasing  the efficiency of the risk they take. Selectivity  is the new catch-word du jour.

“Investors thought they were diversified  going  into the crisis, but soon realised they  weren’t,” says Tom Joy, director of investment  at the Church Commissioners for England  endowment fund.  “Diversification has since fallen slightly out of favour, but it is still a very important portfolio construction tool.”

Nowhere is the concentration-effect more apparent than in hedge funds. Pre-crisis funds of hedge funds would commonly  invest  in 40 to 60 underlying managers in  what some experts describe as an  unsophisticated  risk management framework  that assumed  allocating across more  managers meant spreading risk.

As early as 2002 in a paper entitled Portfolios of Hedge Funds, Prof. Harry Kat, then  professor  of risk at Cass Business  School,  demonstrated increasing the number of  hedge funds in a portfolio led to a lower  standard deviation, but also, and perhaps  less welcome, to a lower skewness and  higher  correlation with equity.

In fact, it is only necessary to combine a small number  of funds (15 or less) to substantially improve  the efficiency of the risk-return profile versus  that of the average individual hedge fund.

David Vickers, senior portfolio manager on Russell Investments’ Multi-Asset Growth  Strategy, argues: “Forty to 60 managers  could mean approximately 2000 underlying  positions. I’m not sure there are 40-60  genuinely  different strategies. The portfolio  will have gone past the efficient frontier in  terms of diversification. Portfolios have become much more concentrated. Within a long only  asset class a portfolio will often  have three to five managers instead of five to  10 managers,  and within a hedge fund of  funds more like 10 to 15. Certainly that’s what we would advocate.

“Relatively concentrated portfolios will give  the best managers the best returns,” he says.  Today funds of hedge funds commonly hold  around 15-20 managers.

Hedge funds and beyond

The arguments for concentration are not confined to hedge fund allocations, however.  The lessons are equally valid across investors’ entire portfolios, especially in light of the popular shift to benchmark-oriented passive  investing of recent years.

Pure passive exposure  to market-capitalisation  weighted benchmarks by its very nature  concentrates risk in large, liquid names.  Because those benchmarks are also more  susceptible to herding as investor buying  pushes up valuations,  increasing the proportion  of the most popular names in the index,  the shift to passive has arguably increased  investors concentration risk significantly.  The result is a greater exposure to bubble  risk as the index continues to allocate more  to increasingly over-valued names.

When the  broader trend towards passive is considered  on top of this, the overall market exposure to  a relatively small number of large caps is  compounded. The impact this double layer of clustering can have was made painfully  clear in 2007.

“Early in 2007 it became clear problems in the mortgage market would hit very widely,”  explains Jeff Holland, managing director and  co-founder of Liongate Capital Management.  “Everyone started shorting financials though  equity and CDS. It became a crowded trade.  Suddenly the market reversed, financials  increased  and investors broadly posted  losses.  The degree of concentration in the  market became clear.”

Cluster risk

A similar hidden cluster risk caused the brutal  unwinding of many large-scale quant  funds in 2008.  In recent years cluster risk may have become  even greater as the continual risk on/risk off  seesaw reduced managers’ comfort with  making risky bets while career risk  increased.

According to Andy Warwick, lead portfolio  manager for Blackrock’s Dynamic Return  Strategies fund: “The global financial crisis  had a clear impact on fund managers’ thinking.  There has been a reluctance to have  punchy, off-benchmark bets since the global  financial crisis. Managers are still very  benchmark aware because of the risk on/risk  off environment and volatility making it  difficult  to take large punchy bets.”

Risk efficiency

Appetite for risk is once again on the  increase.  As the risk on/risk off rollercoaster  has slowed, correlations between and across  asset classes have begun to break down.  “This offers some real diversification benefits  of stock-picking,” Warwick says.  The appetite for managers to increase risk is  particularly true in active management  where the continual focus on cost efficiency  is being translated as a growing pressure to  increase risk efficiency by concentrating  portfolios and exposures where alpha is  more likely to be created.