Is diversification at all costs the right decision? Could diversification of asset classes be masking the real risks associated with investment, wonders Joseph Mariathasan

August is often a quiet time for markets, with very thin trading as it becomes impossible to make any committee-driven decisions within large institutions. Half the committee is on holiday, whilst the other half is preparing to go. But after recent financial markets more closely resembled a roller coaster ride, August may be the right time to think about preparing for the next inevitable crisis.

What institutional investors really want is to have exposure to most, if not all, of the upside of the their investments, but be able to protect themselves from the worst of the downside – so as to protect themselves from tail risk events, so-called “black swans” or low frequency/high impact events. The problem that an institutional investor faces is very different from that of a family foundation and really results from the conflicts between acting as an agent, as institutional managers are doing, and acting as a principal, which is what  a family foundation can, at least under certain circumstances do. After a major crash, Institutional investors are often forced to reduce risk exposures, which means selling equities at the bottom of the market. Investors not faced with explaining their losses to their clients can in turn afford to ride out the downturns and maintain positions hoping markets will bounce back.

Of course, it is possible to buy insurance in the form of put options on a continuous basis, but this would be an expensive proposition. Diversifying asset classes is, of course, the obvious route. But the real question is: how do you measure diversification? Measuring the market capitalisations is one way, but that gives no information about how risky each asset class may be. Another would be to look at risk through a risk parity approach.

However, tail risk assumes non-normal distributions. Therefore a pure risk parity approach may result in a misleading representation of what the risk profile could be in extreme cases. Investors have to beware that they have not entered into a Texas hedge and replaced one risk with another. Diversifying across asset classes may sound a good idea, but if all asset class correlations tend to narrow in a crisis, it does not provide any downside protection, whilst replacing an element of, say, a bond allocation with commodities that may end up being a classic Texas hedge.

The unfortunate truth may actually be that there is no magic solution to managing what really matters to institutional investors, namely tail risk. For they face the problem that a high net worth individual or a family foundation may not face, namely that the agents acting on their behalf have to focus first and foremost on their own career risk and their own firm’s business risk.

As one insurance company fund manager once told me, “We don’t mind going over the cliff as long as we end up doing so after our competitors!” For them, having slightly better performance most of the time would enhance their own and their firm’s success, even if tail risk was increased. The issue that institutions should perhaps focus more on is that financial markets are still unstable. Developed market bonds may be in bubble territory, whilst US equity markets seem to have been treated as a safe haven to deposit money – despite the uncertainties surrounding the US economy.

Now may be the time to think seriously about setting up a systematic risk management plan, to be brought into play in the event of extra-ordinary market volatility that could presage yet another market crash. Having a plan, whether a simple stop loss with position limits to a more complex drawdown control system is certainly better than being forced into exiting the market at the bottom!

Joseph Mariathasan is a contributing editor at IPE