The Red Thread

The Diversification Edition

The art of understanding asset correlations

An introduction from Barry Gill,
Head of Investments

To diversify, or not diversify?

The relevance of this question has arguably never been greater. Diversification is a central tenet of investment theory; from Markowitz, to Sharpe, to Scholes, Black and Merton, measuring and pricing risk consistently entails factoring in diversification. Yet, as the saying goes, “In theory, theory and practice are the same. In practice, they are not.”

At first glance, few would argue against the logic of diversification: ‘Spread your risk’, ‘think in bets’. The reality is more complex though. As Warren Buffett famously said, “Diversification is a protection against ignorance. … [It] makes very little sense for those who know what they’re doing.”

The psychological temptation to jettison portfolio diversity when only a handful of technology stocks would have served well, as would a decision to stay domestic, is huge. And not just for private investors. Style drift happens in equity portfolios as periods of underperformance drag on and the pressure to chase returns mount – even the most robust investment processes, philosophies and egos are susceptible.

This publication is dedicated to exploring the tough realities of understanding and achieving diversification. We interview Professor Paul Marsh, an academic with singular access to market returns data stretching back over 100 years. He offers insights gleaned from crunching correlation data over the last 25 years.

Correlations between assets are dynamic. In ”The non-linearity of diversification,” Michele Gambera, Fatomata Konteh, and Gianluca Oderda analyze and discuss correlations behavior over time and look for trends in certain economic and market scenarios.

In ”Searching for active needles in indexing haystacks,” Ian McIntosh reflects on the challenging environment for stockpickers over the last few years. ”The beauty of indexing” has Boriana Iordanova acknowledging some of the limitations of market cap weighted indexes: she makes a strong case for combining factor indexes together to create respectable risk-adjusted outcomes.

Alternatives are rightly touted as an important portfolio diversifier – though not without risks. In ”Diversifying the diversifier,” Daniel Edelman and Edo Rulli explain how, through the Three Rs of diversification – replication, risk reduction, and representation – multi-managers can broaden access, and capture distinctive market traits. ”The evolving role of private equity,” by Markus Benzler and James Pilkington, looks at whether private equity really can offer diversification, or if it is all just a mark-to-market illusion.

Finally, we take a step out of the pure capital markets lens and look at diversification in the real world. ”Comparative and competitive advantages,” from Max Castelli and Lucy Thomas, explores the delicate trade-offs faced when trying to optimize supply chains, along with the complex interplay between geopolitics and sustainability.

As always, I hope you enjoy reading this edition and welcome any feedback for improvements or future topics.

Barry Gill, Head of Investments, UBS Asset Management