Diversification’s many facets

Ever since Harry Markowitz famously coined Diversification as the “only free lunch in finance”, this term has become the standard go-to phrase for virtually any investor out there. While many believe they know exactly what diversification entails, only a few really understand how multi-dimensional this term really is. Let’s investigate.

The most obvious axis of diversification is moving away from holding single names and replacing them with a basket of securities. Think of this as diversifying away the idiosyncratic risk related to a single issuer – for example, if you hold 100% of your capital in, say, Microsoft, you would be better off spreading your bets across other tech companies.

The next level of diversification is moving away from exposures to a single sector and building a balanced portfolio to all sectors, which in total would reflect the underlying economy much better. In effect, this is exactly what well-known indices such as S&P 500, FTSE 100, DAX, etc. do.

Next comes regional diversification – instead of being exposed to a single country and currency, you may consider engaging in a global opportunity set. For example, you may consider investing in something like the MSCI World Index instead of your own country-specific stock index.

Finally, there comes asset class diversification. Regardless of how wide (in terms of regions and sectors) you spread your equity positions, ultimately they all rely on a single underlying risk factor, hence their internal correlations (especially in times of crisis) remain fairly high. Therefore, what a prudent investor should do is to spread their portfolio risk across multiple asset classes such as fixed income, commodities, and alternatives which – because of their lower correlation to each other – materially improve the risk/return characteristics of their portfolio.

Right, nothing new here, correct? Every serious investor knows what we described above, so why state the obvious?

Well, we’re making the point that diversification doesn’t have to end with sectors, regions, or asset classes

You may be a skillful investor and be able to build a very balanced long-only portfolio consisting of equities, bonds, currencies, and commodities, but ultimately this remains a long-only portfolio. What happens though if you use a different strategy like Trend Following? A strategy that takes the same asset classes as in your long-only portfolio but manages in a completely different way – using long and short positions and harvesting the so-called momentum factor? Well, you will observe that the correlation between Trend Following and your long-only portfolio is virtually zero, which – in effect – means that diversifying across strategies has the potential to achieve a fantastic improvement in the risk-adjusted returns of your portfolio.

Ok, so strategy diversification is useful – is this all we’re trying to say? No, diversification doesn’t end here either.

Take Trend Following as an example. You can deploy a very basic Trend Following system consisting of one entry and one exit rule and can be pretty sure that your performance will be quite good (and better than long-only stocks over time).

However, what happens if you design a second system with a different methodology and set of parameters? Well, using that system (provided it is a robust one) will also produce a fairly decent performance, which (in statistical terms) should be indistinguishable from the returns you would expect from the first system. However, think about what happens when you split your risk budget between the two systems and combine them into a single Trend Following program.

Well, because the two systems are not perfectly correlated, applying them in combination should produce better risk-adjusted returns than any of them individually can achieve. So, system diversification is yet another area of diversification that too few people think about and appreciate.

BUT not Richard Brennan though. Rich was our guest in this week’s episode of the Systematic Investor podcast series and he spent quite a bit of time discussing and explaining the merits and challenges of systems diversification. Curious to find out what Richard had to say about it? We warmly invite you to tune into this week’s episode of the Systematic Investor series and find out yourself.

As usual, we promise that your time will be very well spent.