Better portfolio diversification

=> Portfolio diversification should also take into consideration the ‘style characteristics’ (attributes) of the multiple asset classes, says Josephine Lip, head of retail distribution, Malaysia at Schroder Investment Management. “This approach is referred to as the ‘multiple-asset investment  approach’, where you will invest in various asset classes that include commodities, properties and hedge funds (besides the traditional assets of equities and bonds). The objective is to balance up any underperformance by one asset class with the outperformance of another”.

=> “Different strategies (active and passive) within markets can bring further risk-reducing benefits, as can a degree of investment manager diversification”, Lip adds. Another common diversification strategy is the geographical allocation strategy where investments are spread across regions, says Sharifatul Hanizah Said Ali, managing director of RHB Investment Management Sdn Bhd.

=> Knowledge-based diversification is more than just spreading your investments within and across asset classes. It includes the ability to use well-established principles that seek to minimise loss and extract the best-possible return for any given volatility. “The question you should have in your mind is whether the investments will add value to your portfolio in terms of bringing the overall volatility down for a given expected return or increasing the return for a given volatility,” says Maurice Chia, managing director & chief strategist of Axel Thompson Group.

=> Just because one market stands out as being very lowly correlated to another doesn’y meant it will continue to behave so. “The relationship between asset classes does not remain constant,” says Lip. “We believe a dynamic process to manage the overall diversified portfolio, possibly flexing the asset allocation and keeping on top of the skill-based strategies, is necessary for success.”

=> Add absolute return investments into your portfolio. “Absolute return investment aims to generate positive returns over the medium to long-term, irrespective of the market conditions. This contrasts with most investments that are benchmarked against indices (relative performance) and move in line with markets,” says Chen Fan Fai, chief investment officer of Kenanga Asset Management Sdn Bhd.

Time diversification

According to the research paper “Revisit the debate of time diversification,” published by the Journal of Money, Investment and Banking by EuroJournals last year, Professor Yin-Ching Jan and Associate Professor Ya-Ling Wu of National Chin-Yi University of Technology of Taiwan described time diversification as a concept that says assets’ value is less risky over long horizons than over short ones. It implies that investors are better off holding risky assets in the long run, they say.

One of the lessons of the current bear market is that equities don’t always outperform bonds in all significant time periods. Here is a sample in one market. “The median 10-year return for a sample of 978 Bombay stocks that were listed and traded in 1998 is 10.5%, while the average return is 11.4%. This compares with the 10-year bond yield of 12.2%  in December 1998, implying a negative realised equity risk premium of 1.7% on median returns,” say Ridham Desai and Sheela Rathi, who penned a Morgan Stanley report on 10-year returns last December. Will this mean that long-term risk-taking is not rewarding?

The debate goes on. Many investment experts still hold on that equities tend to outperform bonds over the long term. “This is because recovery and expansionary periods last longer than slowdown and recessionary periods. Barring extreme economic malaises such as the Great Depression in the 1930s and the Credit Crunch in 2008, the global economy sees, on balance, more growth than recession,” says Josephine Lip, head of retail distribution, Malaysia, at Schroder Investment Management. That said, what investors need to give to make their investment portfolios work is time, other than diversification, she adds.

However, it depends on the time frame, and whether you take risk into account or just absolute returns. “It is often perceived that equities outshine bonds most of the time. This may be trun in certain years but not all the time,” says Sharifatul Hanizah Said Ali, managing director of RHB Investment Management Sdn Bhd. “There is a time for different asset classes to perform. For instance, global equities typically outperform global bonds by a slight margin over the long terms of absolute performance basis while global bonds outperform global equities significantly on a risk-adjusted returns basis,” she adds. Professors Jan and Wu concluded in their research that for an investor who cares about the performance of the Sharpe ratio (risk-adjusted measure), it is better to hold a diversified or safe portfolio in the long-run investment horizon, rather than a risky portfolio.

Source: Personal Money, July 2009