The only way you can diversify your portfolio
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MoneyWeek Editor-in-chief
Merryn Somerset Webb Oct 21, 2008
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Cover your bets: buy bonds and equities
One of my richer friends told me last week that he expected his hedge fund holding to be down by around 10% or so by the end of the year. Not bad, he said, given the state of the markets. Hmm, I said, but weren't you expecting it to make you regular absolute returns? Not in this sort of market, he said. All of which made me wonder what sort of market he expected his hedge funds to outperform in.
These alternative investments have long been sold to us as being uncorrelated to the wider equity market and therefore an essential part of a diversified portfolio. When equity markets go down, hedge funds are supposed to keep going up – thanks to their cleverness with derivatives and their ability to go short as well as long. Their managers are supposed to be able to operate above the rough and tumble of ordinary markets and of ordinary investors.
They aren't supposed to lose over 60% in a month, as the Tontine Partners LP Fund is said to have done in September. Or to lose 30% in the last ten months as the average convertible arbitrage fund has done.
Some dedicated short funds have done well, as have some of the so-called 'market neutral' funds. But measured against the promises in so many prospectuses, it all seems a bit pathetic.
Still, hedge funds aren't the only diversifiers that have failed to fulfil their purpose during the crisis.
Private equity is in just as big a mess – it turns out that without non-stop access to cheap money, the new private equity model (buy something, leverage it up, sell it) doesn't work particularly well. Commodities markets – which until very recently were also being touted as uncorrelated to equity markets – are in freefall too.
Even more irritating for those who think that you can reduce your risk simply by investing in lots of different markets, it turns out that there is barely an equity market in the world that isn't moving down in lockstep with all the others. The FTSE 100 is down 38% so far this year. Being invested outside the UK wouldn't have helped, either. Most of Europe is also off nearly 40%, as is the US.
As for emerging markets – the ones we were told to buy to offset troubles in the developed world – no joy there either. Shanghai is off 60% and India 45%. The same goes for the Middle East. Last year, there was a slew of fund launches – all with the phrase "uncorrelated to developed market" sprinkled around in promotional material. I even wrote about them myself. So much for that. Kenya is down 30% and the UAE 45%.
But there is one last hope for fans of diversification – timber. A broker told me recently that he and his colleagues were thinking of launching a timber fund because it is "uncorrelated to any other asset class". He might be right, but when I think of timber, I think of building houses and buying furniture – both things not many people are doing, anywhere in the world. I suspect that it won't be long before timber proves itself to be just as correlated as the property market is.
The truth is globalisation has destroyed diversification as a risk reducer. This wasn't clear in the 1990s and the early part of this century, because most things were on the up and easy credit papered over almost all the cracks.
But we can now see that our financial systems and our economies are so utterly intertwined that it is impossible for serious failures in one part of the world not to make waves everywhere else. So the collapse of the credit bubble and the consequent recession in the west has hit all markets and all asset classes.
When things are sort of fine, lots of asset classes look like they could be uncorrelated. In times of crisis, however – when we really need them to be uncorrelated – they can't be.
The consequences of this could be interesting. If investors know they can't reduce their risk by diversifying, surely they will be prepared to pay less for equities than they would have when they thought they could? That suggests, from now on, the equity risk premium should be higher and price/earnings ratios across the world lower than they have been in decades. More like 8 or 9 times than 15 times maybe? Yet another reason to keep out of the markets for now.
So, back to diversification. In this new environment, there may be one old-fashioned thing you might do to protect yourself over the long term. Once you feel up to moving out of cash (which I do not), divide your portfolio equally between good quality bonds and equities (wherever you like – the geographical region doesn't much matter).
In general, except for in times of inflationary recession, bonds and equities seem inversely correlated: when equities fall bonds rise. And vice versa. Now that's what I call diversification.
• This article was first published in the Financial Times
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