Diversification
diversify / verb (diversifies, diversifying, diversified) make or become more diverse or varied: [with obj.][often as adj. diversified] enlarge or vary the range of products…
– DERIVATIVES diversification noun
The Oxford Dictionary of English is never wrong hence the very deliberate use of the extract above. It is factual in nature and without opinion, it simply states meaning and it is for the reader to interpret in the appropriate manner; it is therefore often that the interpretation may lose focus on the original objective.
Diversification in its simplest form is a risk management technique that involves mixing a wide variety of investments within a portfolio.
It is the spreading out of investments to reduce risks hence minimising the risk from any one investment. Harry Markowitz introduced Modern Portfolio Theory in a 1952 article and later in a book in 1959 maintaining that an investor can reduce portfolio risk simply by holding combinations of instruments which are not perfectly positively correlated. In other words, investors can reduce their exposure to individual asset risk by holding a diversified portfolio of assets. Diversification should then allow for the same portfolio return with reduced risk.
Portfolio construction first steps
The first step with any portfolio construction mandate should always be to assess the investor’s attitude to risk and then carefully match this with their stated objectives. This may sound incredibly simple. However, each investor is completely different and, in my opinion, this step is often reversed. Namely, the investor’s desired portfolio objective is matched to a given risk profile, enabling the adviser to incorporate more real assets (read ‘equity’) in order to deliver the required higher rates of return.
Indeed, given that the expected returns from the major asset classes are not what they were some 10 years ago, it is much more difficult for an adviser to create an efficient portfolio for say, a more cautious investor, without using riskier assets.
Can structured products fit?
Advisers are able to diversify an investor’s portfolio both at a macro and micro level, i.e. start with the appropriate asset class model on a risk weighted basis and then start to diversify and stock pick within each of these asset classes. The major asset classes I have referred to above are Cash, Bonds, Property, Equity and Alternatives.
It is at the micro level that I would like to focus on which is the part that I believe advisers are able to add most value.
At this stage I would like to state (again) that structured products are not an asset class, they are simply another way for an investor to access a specific asset class in a predefined and sometimes, a more efficient way.
It is true, that most structured products also offer some form of capital protection making the pay-off profile more difficult to include in a traditional risk-weighted portfolio. However, surely it is more appropriate for an adviser to adapt his investment approach given the product choice available, as opposed to trying to shoehorn a client into a possibly less efficient portfolio? What I am saying is that sometimes a more pragmatic approach to portfolio construction may better serve the client.
Equity diversification
Using structured products within a client’s portfolio can be much simpler than many advisers believe. I will focus on the equity element of a portfolio as the majority of retail structured products are linked to an equity index of some form and, in the main; the FTSE 100 is the index of choice. Provided that the return profile of any structure at least matches a client’s expected return whilst at the same time delivering an element of capital protection, it should be possible to create and develop a more efficient portfolio for the client by incorporating a variety of structures within the given equity component.
Investec Structured Products have to this point, only issued retail structured products linked to the FTSE100 as we believe that a portfolio with a core holding of the FTSE 100 gives a balanced and diversified exposure to world GDP growth. As a whole, the companies that comprise the FTSE 100 derive more than two thirds of their revenues from outside the UK. Furthermore, we believe that globalisation has diluted some of the benefits of spreading equity investments geographically with correlations between the major equity markets currently upwards of some 75%.
Investec. Taking the lead
Taking the benefit of diversification one stage further we have recently added additional asset providers on some of our retail plans. Investec Bank plc, as the Plan Manager, now offers different versions of some of our deposit and investment plans incorporating an alternative asset provider. Using an alternative asset provider gives clients more choice and the ability to create a more diversified and balanced portfolio. Advisers are now able to not only recommend a plan where an appropriate return profile has been selected, but also with certain plans, discuss the benefits of choosing more than one asset provider with the same Plan Manager. This offers true diversification without the need to look for similar plans from other providers to satisfy the client objectives. We have added Lloyds TSB Bank plc versions to three of our deposit plans, the FTSE 100 5 Year Deposit Plan, the FTSE 100 Roll Over Income Deposit Plan and the FTSE 100 Plus Income Deposit Plan. In addition, we have also added Morgan Stanley versions to two of our investment plans, the FTSE 100 Enhanced Kick-Out Plan and the FTSE 100 Geared Returns Plan. We also intend to add more asset providers with future launches further developing our continuously available retail collection.
To diversify is defined as becoming more diverse or varied; the real skill is doing it in an appropriate and efficient way.
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