Levels Of Diversification And Jargon
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.
Before we go into this, let us cover some investment jargon which is important to grasp 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?
The risk-return trade-off is a principle that states that high risk means higher reward. According to the risk-return trade-off, invested money can gain higher profits only if the investor will accept a higher possibility of losses. Choosing the appropriate risk-return trade-off for our investments can be tricky. It depends on a variety of factors including an investor’s risk tolerance, the investor’s years to retirement and the potential to replace lost funds. Time also plays an essential role to determine which portfolio has the appropriate levels of risk and reward.
Risk- return can be applied at different stages of investing. Namely, Fund Level and Portfolio Level:
Fund Level happens inside a fund, the investor has no control over this type of diversification. It is decided and calculated purely by the asset manager/s of the fund. Risk-return can be achieved in the way that they choose to make up the fund. To illustrate, within a fund that is invested in 100% equity only, risk and reward can be increased by concentrating investments in specific sectors or by placing a large percentage holding on a single company share.
Portfolio Level, this looks at the overall birds-eye-view for the investor. Risk-return in a portfolio could include how individual funds and investments are combined together. This directly influences which type of asset classes (equity, income instruments, property etc) are chosen and blended together into the investor’s portfolio, as well as the ratios which they are blended together. For example, a portfolio has 100% that needs to be divided across asset classes according to risk appetite, years to retirement, potential to replace lost funds, time horizon etc. If an investor has the ability to invest in equities over the long term, that provides the investor with the potential to recover from the risks when markets are down and participate when markets are up. If an investor can only invest in a short time frame, the same equities have a higher risk proposition. Time is key for deciding how much equity should be included in a portfolio.
Correlation is a term used to explain how two things move in relation to one another. Positive correlation means that they move together and negative correlation means that they move oppositely to one another. Correlations are used in advanced portfolio management, in how different funds/shares are put together to try generate a return for our investments. Securities have different levels of correlation. They can move exactly the same (perfectly correlated), in similar directions (correlated), opposite directions (negatively correlated), completely opposite directions (perfectly negatively correlated) or they can have no relationship to each other’s movement at all (no correlation).
No correlation and negative correlation is important when trying to achieve diversification. Meaning, that when one share/fund is losing returns, the others may be gaining. This creates all-round return generation through different market conditions.
Asset Class Exposure
Asset classes are made up of investments which often behave similarly to one another in the market and are regulated by the same laws and legislation. Historically, the main asset classes have been equities (stocks), fixed income (bonds) and cash equivalent or money market instruments.
Currently, most investment professionals include real estate, commodities, futures, other financial derivatives, and even cryptocurrencies to the asset class combination. Each asset class is expected to bring different risk and return make-up and perform differently in market environments. Investors aiming to maximise return can do so by reducing portfolio risk through asset class diversification.
Financial advisors focus on asset class as a way to help investors diversify their portfolio. Investing in several different asset classes ensures a certain amount of diversity in investment selections, to reduce risk and increases your probability of making a return.
Other Relationships Between Funds
Funds can hold different strategies inside their share picking or even a combination of different strategies. These strategies are designed to generate return on investment in different ways. Investment strategies can be tied to growth, value, income or a variety of other factors that help to identify and categorize investment options according to a specific set of criteria. By combining a variety of funds according to various asset manager strategies, which are all uniquely designed to generate return in different ways- diversification is further achieved. At Fairtree Invest, we work with Fairtree Asset Management who have specialised teams who not only constructs these different strategies in unit trusts, but also in hedge funds. At Fairtree Invest we combine Fairtree Asset Managements unit trusts and hedge funds into unique portfolios that maximise return and diversification for our clients.
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.
Fairtree Invest achieves 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
– Kheara Kroggel