Why historic diversification failed a generation, and what managers are doing about it now

Diversification models built over the past 10 years have failed to cut fund volatility significantly.

This finding, published today by asset managers Capital Generation Partners, comes from a study of 30,000 portfolios over 10 years to September 2010.

It also comes at a time some of the industry’s leading asset managers openly question whether a generation of retail investors, so wounded by volatility and a ‘lost decade’ of market falls, will ever return to mainstream assets.

The European head of one of Germany’s largest asset managers said: “Direct equity plays are something the retail investor will now shun. Only if you can package equity investments in such a way to manage the downside risks, will investors come back – and that is where the industry is heading.” 

Various asset managers are producing a variety of products, with different ways to reduce volatility.

Khaled Said, joint CIO of Capital Generation Partners, said the problem with diversification models developed over the past decade is they share money between more asset classes, but these “fundamentally behave in similar ways.

“What people thought of as ‘alternatives’ – such as private equity and real estate – are in fact just another way of investing in equity. Far from diversifying portfolios, they only served to concentrate them.”

Capital Generation Partners said diversifying by six “traditionally defined asset classes” cut annualised volatility over the decade by only 0.4% compared to a two-way split, of 60% equities and 40% in bonds.

Investors with 40% equities, 30% fixed income, 8% in each of private equity and property and 7% in commodities and hedge funds, made 5.2% a year on volatility of 10.6%. Along the way, they suffered a maximum uninterrupted loss of 30.8%.

The more simple 60:40 diversification model made 3.7% a year on 11% volatility, and a similar maximum drawdown of 27.8%.

The approach advocated by Capital Generation Partners is categorising assets in 12 baskets. Three types of asset (equities, debt and cash), have four strategy options within them (discretionary, systematic, directional and arbitrage). And together they made returns of 6.9% on volatility of 5.2% with a 20.5% maximum drawdown.


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