Why real diversification requires discipline

Philip Seager

Capital Fund Management

Investors historically have always struggled with diversification, and it’s logical to wonder why it’s such a difficult goal to achieve. The hard truth, however, is that investment decision makers are compelled to chase short-term performance because it’s the measuring stick for how they themselves are judged. Increasingly the quest for alpha in a turbulent market environment in recent years has led many investors to look at different ways to get real returns, subsequently piling into alternatives – to the point that from one perspective, alts are akin to very expensive beta.

Hedge fund and venture capital investors are bracing for a tough 12 months ahead, anticipating asset valuations will continue a downward trend. New research by Preqin last month found Australian hedge funds experienced their toughest year since the Global Financial Crisis (1).

Some 64% of investors said their hedge funds met their expectations, while only 8% thought they exceeded them. For the remainder of 2023, some hedge fund investors (38%) are optimistic about improved performance (2).

The one key asset class investors are trying to diversify – equities – have generally done well since the 2008 global financial crisis. The pressure is on to produce results year after year, and the penalties – career risks – for not beating the equities benchmark outweigh the incentives for beating it. If you diversify and equities remain on a tear, nobody will thank you for it.

In my experience, investors want a diversifier to go up when the market is down and go up when the market is up. But that is not decorrelation, it’s wishful thinking and a misunderstanding of decorrelation. Being down when the market is down will happen. In a world of short time horizons driven by noise and luck, you must look at the long term to see meaningful results.

Lack of discipline

The longer a drawdown of public markets stretches, the more likely there will be an accompanying markdown of assets in private markets. An increase in correlation of public and private assets can only occur over long timescales due to lack of liquidity – and that’s what investors are experiencing now.

More than half of Australian institutional investors say the current environment is like nothing they've ever seen before and are taking action to rethink their strategies in accordance . Nuveen's EQuilibrium Global Institutional Investor Survey reported last year that 73% of Australian institutional investors said current markets beckoned a rethink of portfolio construction(3).

When equities go up over a long period of time (as they have) a leveraged version goes up even more – but that does not make it a genuine diversifier.

Private equity gives a false sense of comfort that all is well, and investors seem happy to pay for the privilege. That’s what happens when you add up leveraged risk-premia, some factor exposure, some liquidity premium – it creates a deluded notion that there is less volatility in private markets.

A scenario like this leads to lapses in discipline that can permeate the investment process from top to bottom. Trend following is one strategy that can curb these impulses. It is driven by the market force of performance chasers to get ahead of the curve and perform well in a volatile environment susceptible to change.

Investors chase returns, and that creates trends – some investors even trend on trend followers, but trend following is a fat right-tailed strategy with persistent periods of poor performance and infrequent accelerations. It is very difficult to performance chase because in attempting to do so you’ll typically buy high and redeem before the acceleration. That lack of discipline can be costly.

Building true diversification

A typical institutional portfolio these days is a mashup of public equities in the U.S. and internationally, private equity, fixed income, real estate, and hedge funds. Each of those components has exposure to equities – private equity is a leveraged version of equity, so it has equity premium in it; hedge fund indices are made up mainly of equity long-shorts, with equity premium; fixed income indices like the Global Aggregate Total Return Index include corporate credit, and that has equity risk premium in it; and REITs have equity risk premia, too.

Many investors think they’re diversifying, but they’re just loading up on more equity exposure, true diversification can only come from shorting.

Investors must go equity market neutral in stocks, or long/short in asset classes to achieve genuine, uncorrelated diversification.

Should you stop at decorrelation?

It’s one thing to achieve decorrelation – but what about alpha? After all, outperformance is necessary at some point. The current environment is very diverse across geographies – from the tightening of the Federal Reserve to ongoing quantitative easing and yield curve control in Japan. A combination of non-policymaker driven volatility and high geographical dispersion should be good for macro plays. The quantitative easing environment of the past has been driven by big moves in markets driven by policy announcements.

Discipline is everything when it comes to helping investors realise growth and achieve proper diversification in their portfolios. That also means not shying away from volatility originating from markets and recognising it as a real opportunity. Assuming healthy volatility going forward, investments with Commodity trading advisors, macro traders, trend followers, and market neutral equity players could provide decorrelation and the resultant returns investors hope for when they think about diversification.


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Disclaimer Any description or information involving investment process or allocations is provided for illustration purposes only. There can be no assurance that these statements are or will prove to be accurate or complete in any way. This article does not constitute an offer or solicitation to subscribe for any security or interest. 1. Nuveen. (2023). Think EQuilbirum: Reframing the future - 2023 Global institutional investor study. Nuveen.com. https://documents.nuveen.com/Documents/Global/Default.aspx?uniqueId=5309d6ea-dd7a-4d74-b337-ded2e30eef81 2. Prequin. (2023, March 15). Preqin Investor Outlook: Alternative Assets, H1 2023. Www.preqin.com. https://www.preqin.com/insights/research/investor-outlooks/preqin-investor-outlook-alternative-assets-h1-2023

Philip Seager
Head of Portfolio Management
Capital Fund Management

Philip is the Head of Absolute Return at CFM, having joined the firm in 2000. He is globally responsible for research and strategy development for the Absolute Return strategies. Philip originally joined CFM to work on the Discus CTA program and...

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