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.”
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.”
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.