Diversification increases risk to most bond portfolios, study finds

Equity investors are right to see global diversification as a ‘free lunch’. But research out today found for bond holders, diverifying beyond the home market increases risk, particularly for Germans, Swiss, and Belgians.

Investors from these countries allocating to bonds globally, not just at home, found their portfolio’s risk actually increased, by between between 60% and 70%.

This was a key finding of research conducted by the London Business School and Credit Suisse. The risk analysis covered data from 19 major countries between 1972 and 2011.

On average, diversifying bond portfolios globally increased risk by 35%, compared to investing only at home.

Diversifying globally only made sense from a risk perspective for Danes, Americans and Irish, where risk dropped by between 10% and 25%.

The LBS’s Paul Marsh said much of the extra risk in holding bonds came from attached currency risk, not the bond itself.

Supporting this, the research found that hedging out FX effects reduced a global bond portfolio’s risk, on average, by about 30%.

Interestingly, for global equity investors, diversification does work – on average reducing risk by 20%. Norwegians and Finns benefit most (about 50% risk reduction), while South Africans suffer a 25% increase in risk.

For equities, FX hedging only reduces the overall risk by 7%, or 11% for cap-weighted index investors.

These were only some of the interesting findings regarding FX in the study.

It also found that it makes more sense to buy equities and bonds in currencies that have been weak, than ones that have been strong.

For the 19 countries from 1972-2011, USD-based investors made about 2% more per year buying bonds in currencies that were weakest over previous 5-year rolling periods (reviewing annually), compared to buying the same assets using currencies that had been strongest.

For equity holders the difference was sharper – almost 10% more per year.

The LBS also found these extra returns were not because of volatility in weaker currencies – the Sharpe ratios were also higher for weak-currency investors.

In a stark demonstration of how much major currencies have had their buying power eroded over the years, the study found the purchasing power of $1 in 1900 was now less than 4 cents.

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