What Is Diversification?
In our last article we mentioned the importance of diversification. However, what is diversification and how do you achieve it inside your portfolio? We learnt that diversifying a portfolio is incredibly important. Behavioural finance research shows that investors understand the importance of diversification, however struggle to apply it in practice. Many investors struggle to balance risk-return inside their portfolios and rather use a method called; the ‘1/n’ approach. Here, investors take a range of similar funds and allocate to them equally to make up their portfolio. They believe that simply holding multiple funds is diversification. A common example of this is the belief that a combination of a number of different Balanced Funds is diversification – this is not the case. This method ignores specific risk-return characteristics, correlation, asset class exposure and other relationships between the funds selected. Investors may also prefer to stick with assets that they are familiar with.
There are many levels to diversification and we at Fairtree Invest, deploy multiple strategies to achieve diversification inside of our various solutions. In this article, we will explain some of the ways in which we achieve diversification through our three main types of portfolio construction. We will use three of our solutions to illustrate this:
1. Unit Trust (Long Only Construction) – Fairtree Worldwide Multi-Strategy
2. Hedge Only Construction – Fairtree Growth Hedge Fund of Funds
3. Combination Construction (Hedge Funds and Unit Trusts Combined) – Fairtree High Net Worth
Diversification in essence, is finding different ways to create excess return. This creates a massive arsenal of different avenues in which return on investment is achieved. The aim of this is around-the-clock ability to find and capitalise on market opportunities for our clients. We do not just employ one method of thinking, we specialise and deploy multiple value hunting strategies to grow our client’s investments.
Before we review this, it is important to understand some investment jargon in order to understand diversification properly. We mentioned that diversification includes specific risk-return characteristics, correlation, asset class exposure and other relationships between the funds blended together inside our portfolios. So, what do each of these things mean?
We have three main categories of portfolio construction as mentioned previously; Long Only Construction,
Combination Construction (Hedge Funds and Unit Trusts Combined) and Hedge Only Construction. We have a range of different solutions under each of these categories. We will discuss one solution example under each of the categories.
Investment Solution Illustrations
Unit Trust / Long Only Construction – Fairtree Worldwide Multi-Strategy
Diversification in the Fairtree Worldwide Multi-Strategy is achieved on many levels. This is a fund that is used as the core building block to most of our solutions. It is largely an actively managed fund with a portion that is systematically managed by quantitative algorithms. It is our best opinion on growth in a balanced view. Fairtree manages the combination of assets within the portfolio.
Fairtree employs strategic views that largely manage the portfolio, allowing some tactical management to come from Fairtree and outside managers as well. It has holdings globally and locally across different asset classes (property, equity, income instruments and other). It achieves this by selecting funds that are great as a blend when assessing correlation. This ensures excess return is generated differently across each building block of the portfolio, ensuring each adds value to the returns that are generated in a specific and unique way. Multiple investment strategies are deployed especially inside the equity allocation of the portfolio. This accounts for a combination of factor investing in growth, momentum, value, quality and volatility measures using quantitative algorithms with an active management overlay. This fund has a great risk adjust return and is suited for investors looking for moderately aggressive return generation over a period for 5 years or longer.
Looking at returns, we can really see this story come to life and the real effect of diversification. With all the turbulence in the market over the last year other balanced views ((ASISA) South African MA High Equity) were able to return 0.81% on average. Whereas the Fairtree Worldwide Multi-Strategy returned 5.51%. This is a substantial 4.7% out-performance for this Fairtree strategy in the past year. Looking at the rolling 3 year returns, other balanced views returned 3.36% on average and the Fairtree Worldwide Multi-Strategy returned 7.60%. Yet another stellar out-performance.
Looking at returns generated year to date for 2020 other balanced views returned -3.89% on average and the Fairtree Worldwide Multi-Strategy returned -1.54%%. Our strategy protected clients from an additional -2.75% loss.
Hedge Only Construction – Fairtree Growth Hedge Fund of Funds
Let’s first start off by explaining what a hedge fund is and how ‘hedging’ in itself is another form of diversification entirely. Hedge funds offer something called; ‘directional diversification’. Long-only / Unit Trusts make money when the market value goes up. However, hedge funds allow you to take a position based on direction, the market going up or down. It is the position that you take, that determines the profitability. In a normal market crash the value of everything except cash, usually goes down; equity, bonds, property etc… This is where hedge funds come in quite handy and can generate massive returns. In 100% short positions you make money when the market goes down. Hedge funds also have market neutral positions which means that it does not matter which direction the market goes, up or down, depending on your investment position you can money either way. Hedge funds may be aggressively managed or make use of derivatives and leverage in both domestic and international markets. Hedge funds use different investment strategies and are often classified according to investment style. They provide substantial diversity to a portfolio.
So, not only do hedge funds have directional (markets going up or down) diversification, but the Fairtree Hedge Fund of Fund Portfolio also applies diversification through asset classes and uncorrelated investment strategies. This aims to provide an aggressive risk growth opportunity in returns over a rolling five-year period. This portfolio is a combination of award-winning hedge funds, as well as robust capital allocation framework. The portfolio manager aims to provide investors with a combination of attractive returns and downside risk mitigation.
Looking at returns, we can really see this story come to life and the real effect of diversification. With all the turbulence in the market over the last year the JSE All Share TR ZAR was able to return -5.71% on average. Whereas the Fairtree Hedge Fund of Funds returned 9.72%. This is a substantial 15,43% out-performance for this Fairtree strategy in the past year. Looking at the rolling 3 year returns, the JSE returned 3.15% on average and the Fairtree Hedge Fund of Funds returned 11.23%. Yet another stellar 8.08% out-performance.
Looking at returns generated year to date for 2020 JSE returned -10.53% on average and the Fairtree Hedge Fund of Funds returned -5.14%. Our strategy protected clients from an additional -5.39% loss.
Combination Construction (Hedge Funds and Unit Trusts Combined)– Fairtree High Net Worth
Diversification is powerful for portfolio return. Now that we understand what diversification in unit trusts and hedge funds can look like separately, using the two Fairtree portfolio examples above – let us go one step further and really bring this home. Fairtree uniquely specialises in combining incredible unit trust diversification together with hedge fund diversification strategies. In the Fairtree High Net Worth Portfolio solution, we combine the Fairtree Growth Hedge Fund of Funds and the Fairtree Worldwide Multi-Strategy to form an investment portfolio. This really is the full arsenal of diversification methods, achieving diversification by strategically combining asset classes (equity, property, income etc), active management and quantitative algorithms, offshore and local exposure, lowly correlated building blocks, risk-return adjustments and directional diversification.
Looking at returns, we can really see this story come to life and the real effect of diversification. With all the turbulence in the market over the last year the JSE All Share TR ZAR was able to return -5.71% on average. Whereas the Fairtree High Net Worth returned 6.17%. This is a substantial 11,88% out-performance for this Fairtree strategy in the past year. Looking at the rolling 3 year returns, the JSE returned 3.15% on average and the Fairtree High Net Worth returned 8.11%. Yet another stellar 4,96% out-performance.
Looking at returns generated year to date for 2020 JSE returned -10.53% on average and the Fairtree High Net Worth returned -2.52%. Our strategy protected clients from an additional -8,09% loss.
Fairtree investment professionals understand how to do add this value to our client portfolio’s. Simply using the 1/n approach by taking a range of funds and allocating to them equally to make up their portfolio, does not achieve diversification. Allow us to manage the journey and optimise your diversification.
– Kheara Kroggel
Article Credits: Investopedia