Guide to Diversification of Risk in Portfolio Management
Traditional Risk Management within investment portfolios, dictates that the more diverse the asset classes used, the lower the risk levels.
This makes sense, but more and more Investment Managers are starting to look at Absolute Return Strategy as a more effective way to diversify risk.
Traditional Asset classes can be summarized as :
Alternative Asset Classes can be summarized as :
When building a portfolio around the traditional assets, risk can be removed by spreading allocations across a selection, or complete range of alternatives, but two problems have hindered this strategy :
1. Correlation ratios : Asset price correlations are not static, and can be very unpredictable. Asset allocation theory assumes a degree of predictability in correlation ratios that has been difficult to mirror in practise.
2. Liquidity : Asset classes such as Structured Products, Property, PE Funds, and Hedge Funds can be illiquid, particularly if their values are falling. Given the events of 2007/08 most Investment Managers are keen to hold assets that can be quickly moved to cash should the need arise.
It should also be noted that we're only discussing the employment of Alternative Assets as a risk management tool. Alternatives can be used in different ways within a portfolio. Structured Return Products, for example, can produce excellent returns at low risk of capital, provided that the investor is happy to hold products to their maturity should the need arise. Hedge Funds can be used to gain access to obscure asset classes, Distressed Debt is an obvious example.
In terms of pure diversification of risk, however, Absolute Return strategy, particularly Global Multi-Asset, Absolute Return Strategy, can offer a more suitable method of diversifying risk.
Absolute Return Strategy can be employed to dampen the effect of asset price movements, and typically employs the following types of instrument:
Futures & Options
Credit & Interest Rate SWAPs
In very basic terms these instruments can take advantage of general trends and reduce the need to predict specific asset price movements and sensitivities.
Examples would include :
Uncertainty , through Volatility trades
Yield Curve movements
Derivative Instruments also have the advantage of gearing, i.e. the efficient use of capital, liquidity and low dealing costs and defined relationships with the underlying assets.
For further educational research on Alternative Asset Classes, or Absolute Return Strategy, download the following recent Defaqto Reports :
Absolute Returns 2010
Defaqto’s Absolute Return Case Study
Alternative Investment Guide 2010