The dangers of incorrect diversification: Alphen

Greg Flash of Alphen Asset Management writes that while one of Alphen’s investing mantras is diversification, there are hidden dangers in incorrect diversification.

We continually stress to our investors the importance of diversifying between different asset classes and geographically. Diversification is about planning for when things go wrong, not when they go right. If all asset classes were increasing, at the same time, one would naturally want to be primarily invested in that asset class that is appreciating most or fastest. The problem comes when cycles change and things take a turn for the worse. The asset that appreciated most could well be the asset that depreciates the most or fastest.

Having a diversified investment portfolio means that an investor will probably not have the highest possible return in the boom times, however after a crash hopefully the diversified investor will be better off than the investor that had concentrated their investment in just one asset class or market.

There are, however, pitfalls to diversification. One of which is choosing an incorrect blend of assets or markets. We, like many other investment houses, advocate having both local and offshore investments to help to diversify ones portfolio. A problem can be what offshore markets one should choose. Looking only at equity markets and, for simplicity sake, only two indices the MSCI World Index and the MSCI Emerging Market Index, let us compare these to our own All Share Index.

According to MSCI Barra www.mscibarra.com (the provider of the MSCI indices) the MSCI World Index is “a free float-adjusted market capitalization weighted index that is designed to measure the equity market performance of developed markets”. As of June 2007 the MSCI World Index consisted of the following 23 developed market country indices: Australia, Austria, Belgium, Canada, Denmark, Finland, France, Germany, Greece, Hong Kong, Ireland, Italy, Japan, Netherlands, New Zealand, Norway, Portugal, Singapore, Spain, Sweden, Switzerland, the United Kingdom, and the United States. “Similarly, the MSCI Emerging Markets Index” is a free float-adjusted market capitalization index that is designed to measure equity market performance of emerging markets. As of June 2009 the MSCI Emerging Markets Index consisted of the following 22 emerging market country indices: Brazil, Chile, China, Colombia, Czech Republic, Egypt, Hungary, India, Indonesia, Israel, Korea, Malaysia, Mexico, Morocco, Peru, Philippines, Poland, Russia, South Africa, Taiwan, Thailand, and Turkey.

The FTSE/JSE All Share Index (ALSI) is defined as a free float-adjusted market capitalization weighted index.

The graph above compares the MSCI World with the MSCI Emerging Markets and the All Share Index all in rands for the last 20 years. What can clearly be seen is that the ALSI’s total return has been roughly half way between that of the World Index and Emerging Market Index.

The ALSI has demonstrated a volatility half way between that of the other two indices of 20% annualised, compared to 17% and 23% annualised for the World and Emerging Markets respectively. Another number that is very important to be aware of is the correlation ratios between the indices. A lower correlation number is better as it implies more diversification. The World Index had a correlation of 0.45 with the ALSI, whilst the Emerging Market Index had a correlation of 0.67 with the ALSI. Hence to achieve a better risk adjusted return, we would suggest that the ALSI and the World Index should be blended.

So, before you go out and buy a BRIC (Brazil, Russia, India and China) fund to “diversify” against your local portfolio, realise that in doing so you would not be adding positive diversification (reducing risk), but would actually be adding to your risk of capital loss if things go wrong.

The Alphen Angle is an electronic publication of Alphen Asset Management