Diversifying a portfolio is one of the key tools available to an investor, however there are costs to over-diversifying a portfolio including liquidity and transaction costs, according to Ed Tricker, co-head of quantitative research at Graham Capital.
Speaking on a panel about diversification at the Absolute Returns Conference, he told the audience about an experiment to test portfolio diversification on 100 markets showed that a 10 per cent correlation takes out the diversification benefit and has a big effect on performance, he says.
“It is easy to upset that balance, doesn’t take a lot to make things more complicated,” he says.
“As a CTA we have a variety of instruments available, I repeated this experiment with 120 assets, starting with the most liquid and then go down, to build a portfolio. Once you get to 40 or 50 markets you don’t see much more in terms of performance, and when you have 100 or 120 markets it doesn’t look much different to having 50,” he says.
“The key is that when you add assets you want to be adding something idiosyncratic, something that is different to what you already have.”
“At a certain point we introduce correlated markets that does not improve diversification.”
Tricker says that if you are adding more of the same [you] won’t see much more in terms of performance, and superficially it doesn’t hurt performance, so why not do it?
But there are some costs to over-diversifying a portfolio, and one of the principles costs is liquidity.
In addition, in the search for diversity it means looking at some exotic instruments and the liquidity in more exotic instruments is unstable.
There is also an implication for transaction costs as liquidity decreases, the bid-ask spreads typically widen, order books are shallow and therefore transaction costs increase.
“Less liquid assets can cost 15, 20 or 30 times more to trade,” he says. “This is a constant drag on the portfolio that alpha needs to overcome. And there is more certainty around transaction costs than there is around alpha.”
Tricker says there is also a problem of potential problem of tail risk, because when leverage is increased then chance of tail risk is increased.
“Is diversification a good thing? On paper absolutely, it is one of the most powerful things we have. Is it an unequivocally a good thing? Not always, there are some potential problems that creep in.”
Tricker says that investors should be focusing on better portfolio construction, and pay attention to volatility, improve trade execution and cost control.
In particular, if investors want to trade more exotic instruments then they should focus on execution and management of risks.
Ondre Ozer, head of liquid alternatives, TCorp says that when looking for managers, risk management is a key thing.
“A manager can consider risk very differently and you need to be aware of that. Risk is not constant, a manager’s risk tolerance will vary and can be significantly different from your risk tolerance.”
He says in the hedge funds alpha focused space, TCorp invests in global macro, momentum and multi strategy but he points out that investors should more actively manage the allocation between strategies.
“You can do naive rebalancing to get a better Sharpe ratio than a static allocation in for example momentum and rebalance the exposure relative to equities.”
Ozer says investors should diversify across strategies and horizons. For example to manage volatility you can invest in a low volatility alternative risk premia and diversify with high volatility strategies and actively manage the allocation between the different strategies and take risk more opportunistically.
“Without alpha strategies and alternative beta you’re not appropriately managing the risk in the portfolio. Unlisted assets, and yield assets in general are highly exposed to interest rate increases and investors are not being active enough in managing these exposures,” he says.
Sam Mann, managing director of K2 Advisors, who chaired the session, says diversification is the number one topic discussed at K2, both internally and with clients.
Michael Sommers, a consultant at Frontier Advisors, was also on the panel.