While asset diversification is a “great strategy” to reduce risk, it’s important to also consider correlation, according to Australian Fund Monitors (AFM).
While diversification is a “well-accepted” strategy for reducing risk, managers would do well to consider other KPIs such as up and down capture rations and correlation.
“Sayings such as ‘not putting all your eggs in one basket’, or ‘hedging your bets’ are in everyday use in all walks of life, but are particularly relevant to investment risks, whether investing across a variety of asset classes, directly in equities, or via a managed fund,” Australian Fund Monitors chief executive Chris Gosselin told InvestorDaily.
“However even diversification doesn’t always provide the risk protection an investor is seeking, when or if those asset classes are highly correlated, as often happens in times of market stress and volatility.”
Unexpected risks can emerge if funds have a high correlation to each other or the underlying market or asset class involved. AFM compared to two portfolios of 10 equity-based funds, each selected from the same universe of 158 funds investing in Australian and global stocks.
“Portfolio 1 consisted of the 10 highest performing funds over 5 years, irrespective of correlation (which ranged between 0 and 0.81). Portfolio 2 consisted of an optimised portfolio designed to maximise its Sharpe ratio, but in doing so minimise correlation,” Mr Gosselin said.
Portfolio 2 saw significantly better performance, with a worst month of -6.09 per cent compared to Portfolio 1’s -11.78 per cent and a drawdown of -8.24 per cent compared to -14.93 per cent.
“Selecting funds with the benefit of hindsight and past performance of course makes the task easy – but the message is clear when considering the level of risk – optimising for low correlation creates a significantly more diversified portfolio, still with excellent performance, but significantly lower risk,” Mr Gosselin said.
The Australian financial services have been warned to clean up their act in the wake of a number of bombshell sexual harassment claims. ...