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Most investors consider a bank account to be the safest component of their investment portfolio but the recent events with Northern Rock bank in the UK are a timely reminder that unexpected risks lurk behind unforeseen events.
The 2007 Sub Prime crisis caused a global credit crunch that effectively cut off the funding requirements of Northern Rock and led to the first run on a UK bank for over 150 years. In this case depositors were fortune as the UK Government took the unprecedented step of nationalizing the bank and thereby protecting deposits. Depositors are not always so fortunate though; in 1991 30,000 account holders with BCCI lost in excess of ?6 billion when, what was the 7th largest bank in the world at the time, collapsed in a scandal of fraud.
Whilst banks and building societies are still relatively safe homes for short term cash requirements it is worth remembering that statutory protection of bank deposits is very limited and often non-existent. In the UK for instance the Financial Services Compensation Scheme only protects the first ?35,000 of a bank deposit. In the popular offshore financial services centres such as Isle of Man compensation is much lower and there is no statutory protection of deposits at all in the Channel Islands.
Hence the best way of safeguarding against a significant loss is to spread your bank accounts and time deposits across a number of reputable banks.
Diversification is also the most powerful tool for minimizing the risks to your investment portfolio. Mutual funds and unit trusts are subject to many more layers of risk than a simple deposit: asset type risk, manager risk, institution risk and fraud. It is prudent therefore to spread your investment portfolio across a large number of funds from different investment houses so that the failure of any single fund has a minimal negative impact on your overall portfolio.
Such broad diversification used to be costly to achieve and required a very large investment sum. Nowadays though with the proliferation of ‘fund of funds’ broad diversification is achievable even with modest portfolios.
Broad diversification also allows investors to gain exposure to much more volatile investments by combining funds that have a low correlation with each other. In essence it is not the volatility of a single asset that is important to overall risk but the co-variance of all the selected assets. Whilst this concept is not new, the Nobel Prize winning Harry Markowitz developed “Modern Portfolio Theory” in the 1950’s, the range of alternative investment funds available to retail investors today make it much easier to employ effectively. A Markowitz Efficient Portfolio is one where no added diversification can lower the portfolio’s risk for a given return expectation, or alternately, no additional expected return can be gained without increasing the risk of the portfolio.
Until quite recently a typical private investor’s portfolio consisted of equity funds, bond funds and cash, often with single country exposure, which meant limited opportunities to reduce correlation. Today a modern portfolio can achieve far more diversification by using the wide array of funds employing alternative strategies and by making use of multi-manager funds.
Equities: A global equity portfolio is now very easy to achieve by utilizing ‘fund of funds’ whereby one manager selects different funds in each sector and each country based on a ‘best of breed’ approach. No single manager can be the best in every single market but a fund of funds allows a manager to construct a portfolio made up of 15 or 20 of the best sub-managers.
Bonds: Similarly a fund of bond funds can provide exposure to the best bond managers worldwide and also provide diversification across sovereign debt, emerging market debt as well as corporate bonds of all ratings.
Property: Despite the current weakness in the US and UK property markets, property is still a core asset type that should form a part of any well-diversified portfolio. The growing number of Real Estate Investment Trusts (REITs) and funds of property funds make it increasingly simple to gain exposure to global property markets encompassing residential and commercial property. There are also less cyclical property strategies that invest in student accommodation or reversionary ground rents whereby the return is largely independent of property value fluctuations.
Commodities: Investing in commodities used to be the preserve of large institutional traders but recent years have seen more and more commodity focused retail funds coming to market. Some of these invest in all types of commodities whilst others are more specialist and focus on single assets such as gold, or asset classes such as agriculture. Whilst we have seen a strong run up in the price of many commodities such as gold and oil in recent years, commodity cycles generally last between 15 and 20 years, and many experts suggest there is a lot of upside left for most commodities due to the industrialization of countries like China, India and Brazil. The JP Morgan Natural Resources Fund managed by Ian Henderson has returned 476% growth in the past 5 years and provides exposure to precious metals, base metals, energy and soft commodities through a single fund.
CTAs: One of the most exciting and useful new fund types for portfolio diversification is the CTA fund – or Commodity Trading Advisors. CTA funds invest in commodity futures and options and seek to achieve absolute positive returns. In other words whether markets are rising or falling a CTA fund can achieve positive returns for the fund by taking long or short positions. Most CTA funds used sophisticated computer models to trade commodity markets based on price movement trends. Such models can run 24 hours a day, 365 days a year seeking to eke out gains from trends in over 100 global commodity markets with very little, if any, human intervention. The higher volatility and low correlation with traditional asset types make CTA funds ideal tools for diversification and their non-directional returns mean they can add valuable upside to portfolios even during severe equity bear markets as the graph below shows. During the technology crash of 2000 and 2001 (shaded area) Man Investment’s flagship AHL Diversified fund continued to generate strong positive returns. The compound annual growth rate of this fund since inception in 1990 is over 17% per annum.
Hedge Funds: Hedge fund is a generic term that is applied to many varied types of alternative investment fund. Generally speaking hedge funds have the ability to go short in a market as well as long and therefore generate absolute positive returns regardless of market direction. There are numerous different strategies that hedge fund managers can employ which can be broadly grouped in three categories, ‘opportunistic strategies’, ‘relative value strategies’ and ‘event driven strategies’. The performance of hedge funds is more directly attributable to the manager’s skill than with traditional long only funds so they are sometimes perceived as high-risk investments for the mega-wealthy. Nowadays however there are so many different hedge funds with different risk profiles and a growing number of ‘fund of hedge funds’ so it is relatively easy to gain exposure to a wide range of managers and strategies with as little as $10,000. Some of the multi-manager funds even come with a capital guarantee underwritten by large banks such as Citibank and HSBC so you can never lose your capital. Furthermore they offer rising guarantees so that each year a portion of profits is locked away and added to the final guaranteed amount. The chart below shows the incredible growth in this sector and gives an indication of the choice available.
Selecting the best funds from reputable fund management houses will always be a core discipline of successful portfolio management. However the increasing availability and accessibility of alternative investment strategies though ‘fund of funds’ and multi-manager investments allow the private investor to achieve far more diversification. This not only increases potential returns and reduces volatility; it also means that one unforeseen failure is not going to have a catastrophic effect on your overall wealth.
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