WHY PORTFOLIO DIVERSIFICATION IS SO IMPORTANT.
Variety of approaches can reap benefits
When asked what portfolio diversification means it is not unusual to get many different responses among investors and industry professionals alike.
While the basics of dividing a portfolio among stocks and bonds according to risk has not changed, the larger one’s portfolio gets the greater the need for diversification among different types of managers and asset classes.
However, in reality many investors do not adapt their portfolios as they grow, instead sticking to the typical 60/40 Canadian Balanced model portfolio.
As an Outsourced Chief Investment Officer we work closely with a wide range of ultra- high net worth clients and their family and multi- family offices. What we’ve really started to notice among both our clients and our network of family offices is the move toward the deployment of more of an endowment model when it comes to portfolio diversification.
This means utilizing passive and active public market portfolios along with risk- managed, low- volatility strategies. For those with very large portfolios there can also be a component of private equity, direct co- investing, venture cap, private debt, and real estate.
As an extreme example, according to the 2017 UBC/ Campden Wealth Global Family Office Report the average family office will hold quite the diverse portfolio with multiple managers divided among 15 different asset classes in both the public and private markets.
While t hese f amilies have average assets in the hundreds of millions of dollars it does show that they undertake extensive diversification. For the average investor with over $ 1 million in household assets going to this level of diversification is not possible nor recommended but this also doesn’t mean having one manager in a simple long- only balanced mandate.
Why not divide up the portfolio among a couple of different managers with a balance of fixed- income, active, passive and risk- managed investment strategies weighted according to your ability and willingness to take on risk?
There could even be a smaller allocation towards private equity to add some torque to the portfolio.
Another common problem we’ve noticed is the tendency toward herding into those managers with strategies currently in favour and outperforming in the near-term. So instead of having multiple managers with different styles and investment philosophies, in the end the portfolio ends up being highly concentrated into one or two managers doing the same thing in the same markets.
For example, when we conduct quarterly reviews of each portfolio manager we oversee, it is not uncommon to notice that some do particularly well while others may be challenged by the market environment in the near- term such as over the past one to three years. In these cases we often have to remind ourselves that this is OK as you do not want the different portfolio managers and strategies to move together and that the total portfolio’s longer- term objectives are on track to being met.
That said, there are times when managers need to be changed out.
The key when making such a decision is not to chase those whose strategies have delivered strong nearterm returns otherwise you risk losing the benefits of diversification when markets correct.
What we do look for as part of our review is when a manager is consistently underperforming other peers in their category or worse, they capitulate on their investment process such as a value-based equity manager shifting their portfolio towards more momentum-focused holdings.
Finally, another mistake that is often made is when an investor has a mismatch of portfolio holdings to what they are trying to achieve as outlined in the investment policy statement.
For example, this could include not holding enough passive equity positions for those that find it important to keep up with and track the market — although we would doubt they would want to track it when markets correct.