JOHN GILCHRIST: Why diversification is a crucial part of the risk discussion

Measures of risk are imperfect, but their ease of use makes them ubiquitous in the investment industry. They have become part and parcel of the screening tools of asset aggregators and especially portfolio constructors such as discretionary fund managers, who aim to develop multi-managed portfolios that suit their clients’ return and risk needs.

However, their ease of use presents some pitfalls — including potentially focusing too much on each fund on a stand-alone basis.

Diversification is often referred to as the “only free lunch” in investing, but an overreliance on stand-alone fund risk measures can cause the important benefits a fund manager can add through diversification as part of a multi-managed solution to be overlooked. 

Not all risk is created equal 

Most investors understand that exceptional performance cannot be generated without taking on risk. However, investors need to be rewarded for any additional risk they take on, both on an absolute and a relative basis. As long-term investors we often find that the best investment ideas can be volatile over shorter periods despite a strong fundamental underpin. At PSG Asset Management we think taking on some short-term volatility risk (where the investment horizon allows you to do so) to help generate returns is appropriate, provided you can manage the actual risk (as measured by, for example, maximum drawdown) within the client’s risk tolerance. 

It is interesting to note that if you separate the funds in the SA Multi-Asset High Equity fund category (balanced funds) into quintiles based on volatility, there is a clear link between volatility and performance. Higher performing funds generally display higher volatility. However, when doing the same analysis based on maximum drawdown there is no clear pattern.

This implies that fund aggregators that penalise funds for high volatility may underperform over time, while those that are more selective may be able to construct better performing multi-managed solutions with lower actual risk characteristics.

Stand-alone risk versus risk in a multi-managed context 

Most investors either access funds as part of a multi-managed solution or invest in a few funds to reduce individual fund risk through diversification. Assessing fund risk on a stand-alone basis is materially different to assessing fund risk in a multi-fund investment. Correlation of excess returns becomes a crucial consideration.

While volatility on a stand-alone basis is seen as a bad characteristic, in the context of a multi-fund investment the addition of a more volatile fund with a low correlation to the others can actually increase returns and reduce overall portfolio risk.

This is probably best illustrated with a tangible example by considering a multi-managed balanced fund comprising an equal weight in each of the three largest funds in the category — funds A, B and C.

PSG Balanced Fund has a volatility of 13.7% and a maximum drawdown of minus 8% over this period, and therefore could be seen as risky from a volatility perspective on a stand-alone basis (and average risk in terms of drawdowns). However, with a low correlation to the above three funds, adding the “risky” PSG Balanced fund to the basket at an equal weight of 25% materially increases historic returns, marginally increases volatility, and reduces drawdown, making for a vastly improved risk-adjusted return. 

The takeaway is that investing only in lower volatility funds is likely to have a negative effect on returns, while not necessarily reducing actual risk as measured by maximum drawdown, for example. It also implies that the qualitative manager selection process used by discretionary fund managers and multimanagers is a crucial step in the process, as a purely quantitative analysis may have significant shortcomings. 

Differentiation becomes more important if the future looks unlike the past and present 

While we do consider historic data (including volatility) when constructing our own portfolios, we are always cognisant that the future may look materially different from the past. We view the period after the global financial crisis as an anomalous period of low inflation, low growth and low interest rates.

Our fundamental bottom-up research supports the view of a future with higher inflationary pressures and higher interest rates. This in turn has material implications for developed market fiscal sustainability, particularly given the current high deficits. Ultimately, a move away from the post global financial crisis regime means the winners of the past are unlikely to outperform in future.

We expect passive funds and funds with low tracking errors to underperform substantially in this scenario. Therefore, including a truly differentiated fund as part of a multi-managed solution could pay off handsomely in this challenging environment.

Don’t underestimate the value of diversification in managing risk 

While we believe both performance and the client journey are crucial considerations for investors when selecting funds, in the context of multi-managed solutions an excessive focus on volatility as a risk measure could yield suboptimal outcomes.

Funds that can look risky on a stand-alone basis when focusing on volatility can improve return and reduce risk when added to multi-managed solutions, as low correlation of returns can be a material risk mitigator.

• Gilchrist is chief investment officer at PSG Asset Management.