How to optimize portfolio diversification

During our Conference Call with Fund Selectors, where we discussed portfolio diversification, we had the privilege of welcoming three experienced investment professionals who provided for a rich and insight-packed discussion.

Our three guests, Karol Ciuk, CFA, Head of Global Strategies at Pekao TFI, Bruno Dhoosche, CFA, Head of Investment Research & Head of Fixed Income Strategies at Allfunds, and Andrea Profeti, CFA, Senior Investment Fund Advisor at Indosuez Wealth Management, came prepared with a handful of sound investment advice when it comes to how, and most importantly when, to best diversify an investment portfolio, drawing from their experiences in past economic downturns.

Continue reading below to catch the high points from the conversation, and to re-watch the call recording in it's entirety.

We began the conversation with two quick questions introducing the topic: Why is now the time to double-down on portfolio diversification? When can we expect the economic turnaround to begin?

Andrea perfectly explained why, as an investment professional, now is perhaps the most critical time to evaluate portfolio risk, and ensure proper diversification across strategies:

Swift and coordinated central bank action, in addition to the recent positive news on the vaccine front, lead Karol to believe that the tides will begin to turn in 2021, as early as the first half. The downturn in markets in March was painful, he said, but the swiftness of governments and central banks in deploying support programs is what allowed for a rather quick bounce-back.

So, looking ahead to 2021, what advice did our guests provide do efficiently diversify portfolios?

Andrea Profeti, CFA, Senior Investment Fund Advisor at Indosuez Wealth Management

Andrea distinguishes between two types of portfolio diversification strategies: naive diversification and optimal diversification. Whereas naive diversification involves selecting a variety of types of securities, hoping this will lower the risk of the portfolio, the optimal diversification focuses instead on the correlation between securities. Correlation, says Andrea, is the most important factor when targeting diversification.

One limitation that requires continuous re-evaluation in order optimize diversification, is that correlation among assets are not constant, and they can change quite abruptly, making the diversification strategy less effective. Also, in extremely negative conditions, correlation between securities tend to converge, counteracting the diversification the strategy looked to achieve in the first place.

Andrea recommends regularly stress testing your portfolio, and taking preemptive measures to rebalance your portfolio with a variety of assets differentiated by country industry and company size.

Karol Ciuk, CFA, Head of Global Strategies at Pekao TFI

Karol demonstrated how, in practice, an effectively diversified portfolio could withstand market turmoil and Black Swan events.

During the market drawdown in March, the only asset class that didn't turn negative was US treasuries, with even US corporate triple A bonds, unanimously considered 'safe', losing nearly 7%. Karol suggested that the hypothetical US balanced portfolio, which combines US treasuries and US equities, can be a solution to portfolio diversification.

Since 1988, return contributions from the US balanced portfolio have been split between US treasuries and US equities. Most notably, during times of crisis like the dot com bubble of the 2000s, the portion of the portfolio held in US treasuries prevented a huge downturn in the overall portfolio, and limited the investor's overall loss. The same situation happened in 2008, when equities plummeted but US treasuries helped buoy the portfolio.

In terms of correlation, Karol pointed out that the US balanced portfolio has exhibited negative correlation since the early 2000s, an important factor when evaluating diversification strategies.

Bruno Dhoosche, CFA, Head of Investment Research & Head of Fixed Income Strategies at Allfunds

The need for diversification, says Bruno, stems from the fact that, as investors, we know that distribution of returns are not normal. Tails are fat, Black Swan events happen, and in the past 20 years, they have been happening more frequently than predictions. A balanced portfolio helps mitigate the risk associated to such events.

The fluidity of markets continuously changes an investor's need for diversification. A commonly overlooked requirement for portfolios, according to Bruno, is constant rebalancing and ensuring the intended diversification strategy continues to benefit the portfolio in the long run.

Bruno mentions the following quote by renowned economist John Maynard Keynes to highlight the fact that investors who may have the right long-term predictions may still become insolvent if they do not deploy a diversified asset allocation strategy that can weather shorter-term market fluctuations.