Prudent diversification is one of the central tenets of modern portfolio theory. Since different financial assets often change in value in opposite ways, it is possible to combine them to produce a portfolio that has lower risk than the individual assets.
For example, when prices in the equity market fall, bond prices often rise, while emerging equity markets will often perform well at times when developed markets are struggling. Combining assets such as these in a portfolio can help reduce the overall volatility of returns and give investors a smoother ride.
The key thing to understand when building such a portfolio is the correlation – the way these assets behave in relation to each other.
Correlation is the statistical term that measures how two securities or markets move in relation to each other. It ranges from +1 to -1. A perfect positive correlation of +1 means the two assets move in lockstep, whether higher or lower. A perfect negative correlation of -1 shows the securities move in directly opposite directions. When one moves higher, the other goes lower by the same amount, and vice versa. A correlation of zero means the two securities behave independently and are essentially random.
Combining assets with a low correlation to each other is the starting point for a portfolio said to be diversified.
If you hold just two assets in a portfolio, even if they have a low correlation to each other, there is still remains a high degree of risk. If these are companies, there is a risk that company-specific news will have a negative impact on the share price.
The way to reduce this so-called ’unsystematic risk’ is to hold a range of investments so that the risk from each individual investment is reduced.
In practice, the majority of investors now participate in the financial markets through unit trusts, open-ended investment companies and offshore mutual funds as a way of helping mitigate this risk.
Many investors also like to build a degree of exposure to emerging equity markets into their portfolios as a way of diversifying risk, as well as gaining exposure to these fast-growing, if volatile, economies.
As a diversifier of risk, this has been a successful strategy. Over the last three years, emerging markets have returned in the region of 25 per cent in sterling terms, even allowing for the sharp falls seen towards the end of 2008. This compares with a fall in value across many of the world’s developed markets over the same period. The FTSE All-Share is still 20 per cent lower than it was this time in 2007, and global developed markets are little better.
For large investment portfolios it is possible to take this principle and go further, investing in specific emerging market regions, to diversify more, for example.
The Latin American markets typically have a lower correlation with global equities than a general global emerging markets strategy, for instance, the frontier markets of the Middle East and North Africa have a correlation of just 0.14 with global equities.
As a means of helping to reduce the overall level of risk in your portfolio, we believe having a modest exposure to lowly correlated assets can offer valuable diversification as part of a prudently diversified investment portfolio. The key thing is to ensure the degree of exposure is proportionate and is in keeping with the appetite for risk of your client.
Ian Pascal is marketing director at Baring Asset Management