Why diversification is a crucial part of the risk discussion - Angles & Perspectives Q1 2024

Why diversification is a crucial part of the risk discussion

Measures of risk are imperfect, but their ease of use makes them ubiquitous in the investment industry. They have become part and parcel of the screening tools of asset aggregators and especially portfolio constructors such as discretionary fund managers (DFMs), as they aim to develop multi-managed portfolios that suit their clients’ return and risk needs. While we have argued that some risk measures like volatility are not ideal (here and here), nor an accurate reflection of the real risk the investor faces (as argued in Assessing risk in the energy sector in this edition), they remain easy to calculate and compare. However, their ease of use presents a number of pitfalls investors should be aware of – including potentially focusing too much on each fund on a stand-alone basis.

Diversification is often referred to as the ‘only free lunch’ in investing, but an over-reliance on stand-alone fund risk measures can cause the important benefits that a fund manager can add through diversification as part of an overall investor portfolio or multi-managed solution to be overlooked.

Not all risk is created equal
Long-term investors understand that exceptional performance cannot be generated without taking on risk. However, investors need to be rewarded for any additional risk they take on, both on an absolute and a relative basis. As long-term investors, we often find that the best investment ideas can be volatile over shorter periods despite a strong fundamental underpin. We think taking on some short-term volatility risk (in portfolios where the investment horizon allows one to do so) to help generate returns is an appropriate trade-off, provided one can manage the actual risk (as measured by maximum drawdown, for example) within the clients’ risk tolerance.

However, the market experience in 2020 in the immediate wake of the Covid-19 pandemic highlighted to us that we should consider the investment process more holistically and with the overall client journey in mind. At PSG Asset Management, we pride ourselves on being a learning organisation, and challenging periods often provide the greatest opportunities to reflect, learn and incrementally enhance processes. Therefore, we made a number of incremental enhancements to our process while ensuring we remain true to our essence. This included:

• Ensuring our equity buy-lists cater for all funds (not just the equity funds), by being more cognisant of what each share brings to the portfolio, and thereby allowing lower-risk funds to create more diversified equity portfolios.
• Focusing on position sizing given the asset quality and context.
• Focusing more on the macro environment and the potential scenarios that could negatively affect our portfolios.
• Using hedging derivatives.
• Stress testing, scenario analyses and factor analyses of portfolios.

The aim was to continue to deliver exceptional performance while improving the client journey as measured over an appropriate time horizon for each fund. The focus was not on reducing volatility, but rather on improving the client journey, which we believe is best measured by more meaningful risk measures like fund drawdown.

A practical example of why volatility should not be the only measure of risk
With this in mind, we see that while the PSG Balanced Fund delivered exceptional performance over the four years ended 31 March 2024, it appears to have done so at fairly high volatility.

However, despite this higher than average volatility, the maximum drawdown over this period was in line with the peer average.

For the PSG Balanced Fund, higher than average volatility has not meant higher actual risk over this 4-year period since we introduced the incremental enhancements.

It is interesting to note that, if one separates the funds in the SA Multi-Asset High Equity fund category into quintiles based on volatility, there is a clear link between volatility and performance. Higher performing funds generally display higher volatility. When doing the same analysis based on maximum drawdown, however, there is no clear pattern.

This implies that fund aggregators that penalise funds for high volatility may underperform over time, while those that are more selective may be able to construct better performing multi-managed solutions with lower actual risk characteristics.

Stand-alone risk versus risk in a multi-managed context
Most investors either access funds as part of a multi-managed solution, or they invest in a number of funds to reduce individual fund risk through diversification. Assessing fund risk on a stand-alone basis is materially different to assessing fund risk in the context of a multi-fund investment. Correlation of excess returns becomes a crucial consideration. While volatility on a stand-alone basis is seen as a bad characteristic, in the context of a multi-fund investment the addition of a volatile fund with a low correlation can actually increase returns and reduce overall portfolio risk.

This is probably best illustrated with a tangible example.

Below is a visual representation of the correlation of excess returns of single manager balanced funds as measured over five years to 31 March 2024. Simplistically, funds in the same segments are highly correlated (for example Funds B and C), while those in opposite segments have a negative correlation (for example Fund C vs PSG Balanced Fund). Funds A, B and C also happen to be some of the largest funds in this category.

Next, let’s consider a multi-managed balanced fund comprising an equal weight in Funds A, B and C.

PSG Balanced Fund has a volatility of 13.7% and a maximum drawdown of -8% over this period, and therefore could be seen as risky from a volatility perspective on a stand-alone basis (and average risk in terms of drawdowns). However, with a low correlation to the above three funds, adding the ‘risky’ PSG Balanced Fund to the basket at an equal weight of 25% materially increases historic returns, marginally increases volatility, and reduces drawdown, making for a vastly improved risk-adjusted return.

This is illustrated graphically below – return is improved and risk is reduced:

The takeaway is that investing only in lower volatility funds is likely to negatively impact returns, while not necessarily reducing actual risk as measured by maximum drawdown, for example. It also implies that the qualitative fund manager selection process used by DFMs and multi-managers is a crucial step in the process, as a purely quantitative analysis may have significant short-comings.

Differentiation becomes more important if the future looks unlike the past and present
While we do consider historic data including volatility and correlations when reviewing portfolio construction, we are always cognisant that the future may look materially different from the past, and we apply a fundamentally supported common sense overlay.

We view the period post the Global Financial Crisis (GFC) as an anomalous period of low inflation, low growth and low interest rates. Our fundamental bottom-up research supports the view of a future with higher inflationary pressures and higher interest rates. This, in turn, has material implications for developed market fiscal sustainability, particularly given the current high deficits.

Ultimately, a move away from the post-GFC regime means the winners of the past are unlikely to outperform in the future. We expect passive funds and funds with low tracking errors to underperform substantially in this scenario. Therefore, including a differentiated fund like PSG Balanced Fund in a multi-managed solution would pay off handsomely in this challenging environment.

We believe 2022 provided a sneak peek of what this environment could look like: during the calendar year, PSG Balanced Fund outperformed the average fund in the ASISA Multi-Asset High Equity category by 9.4%.

Don’t underestimate the value of diversification in managing risk
While we believe both performance and the client journey are crucial considerations for investors when selecting funds, in the context of multi-managed solutions we caution against excessive focus on volatility as a risk measure, and highlight that low correlation of returns can be a material risk mitigator. Funds that can look risky on a stand-alone basis when focusing on volatility (like PSG Balanced Fund) can improve return and reduce risk when added to multi-managed solutions.