Better understanding of portfolio diversification is needed, says Watson Wyatt

Last year's market turmoil will lead to more careful thinking about how alternative investments are used in portfolios and about diversity in general, says Peter Ryan-Kane, Hong Kong-based head of portfolio advisory for the Asia-Pacific region at global consulting firm Watson Wyatt.

In a presentation titled 'Diversity -- dead or alive?' at a Watson Wyatt investment conference in Hong Kong on Friday, Ryan-Kane said alternatives can help reduce risk by 3% and boost returns by 1% annually in a typical portfolio. However, they failed in this regard late last year, he said, adding: "The diversity properties of alternatives reduced and they behaved in a more equity-like fashion."

He went on to set out other lessons asset managers and investors have learned about portfolio diversification and management from the global financial crisis -- and some that they still need to take on board. For example, they have become more aware of the fact that returns vary significantly by strategy and over time, and also that it's often very difficult to separate alpha from beta.

It is also now widely understood that although unlisted assets can smooth returns, they can also have some very significant side-effects. "One of the most obvious is where you have different cohorts of investors invested in the same kind of strategies," says Ryan-Kane, some of whom accept they are in a strategy for the long term and others who are much more prone to rush for the exits. "So bifurcation around types of clients is going to be a feature in the future," he says. "Asset gatherers will need to be more careful about the types of investors they group together and think more about their liquidity preferences and risk preferences."

As for investors, there are still very few anywhere that truly understand all the risks of investing in alternatives, says Ryan-Kane. "The degree of complexity of these assets is understated in bull markets, not only from a return and risk point of view, but also from an administration point of view," he says. A major problem this poses is that a traditional equity-and-bond portfolio alone may not be ideal, but alternatives are complex and challenging -- so how do you marry the two themes?

He went on to outline a number of other factors that investors and asset managers should be aware of, adding that "good portfolio-construction principles still apply". For one thing, stakeholder engagement is more important than ever, because members, beneficiaries and so on are becoming more knowledgeable about their funds and the potential market impact on their strategies.

One should also always "invest with the right time frames -- and that is not always forever", says Ryan-Kane. "You should be prepared to sell. There is a pathological aversion in the industry to selling anything -- it tends to acquire assets, but doesn't dispose of them anywhere near as nimbly as it buys them."

With regard to investment themes and types, he adds, don't over-diversify. "You don't have to invest in everything, as trying to do so can cause administrative burdens and can over-diversify the portfolio," says Ryan-Kane. "Find two or three things you really passionately believe in, can research well and that you can really get behind and live through the volatility."

He also noted that long-term planning is critical. "A lot of people were caught out [in the crisis] by not knowing what gate requirements were on funds or what the potential structure or implications were."

Diversity of assets is certainly important with regard to risk management, but perhaps even more important in this respect is "diversity of viewpoints", adds Carl Hess, New York-based global practice director at Watson Wyatt Investment Consulting. "This is the reason we have trustee groups rather than single trustees in most of the jurisdictions where asset pools are funded -- so that we don't have over-reliance on any one model or any one set of views."

Among Ryan-Kane's conclusions to his speech was that Watson Wyatt sees diversity as key to smart portfolio construction. He went on to say: "More than ever, investors require a good understanding of risk in all its dimensions. Sounds like an obvious statement, but if you'd said it a year ago, most people would have yawned."