Sunday, July 26, 2009

Diversification revisited - how and how much (2)

In my previous post on how and how much I should diversify the private portfolio, I concluded by identifying two risks that I should aim to reduce through diversification:

(i) the risk of positive correlation among asset classes; and

(ii) the risk associated with individual assets.

The latter risk is the easiest to address - I simply do not put a material amount of money into any single asset. In this respect, I am less concerned with real estate as the risk of a single property suffering total loss of value is (in my opinion) not material. Absent earthquakes, wars, nationalisation etc property does not disappear. Shares are another matter. Shares can and do go to zero value without any prospect of recovery. It happens all the time - even to very large well regarded companies. In terms of diversification against this risk, the largest allocation we have to a single property is 6.05% of net assets (our home) and the largest allocation we have to a single share is 0.9% of net assets (Westpac Banking Corporation) . Most of our shares are around 0.6% of net assets at the time of purchase. If one company I have invested in becomes the next Lehman Brothers, Enron etc the impact on the private portfolio will be trivial.

The risk of positive correlation among asset classes is much harder to address. During the credit crisis and the years which preceded it, most of the major asset classes showed higher degrees of positive correlation than is desirable from an asset allocation perspective. During the crisis itself, real estate, equities, corporate bonds and commodities all moved down sharply. Of the major asset classes only government bonds advanced (negative correlation) and gold more or less went sideways (low correlation).

In Hong Kong I have a problem that low cost index funds are few and far between. US funds are not available and the next best thing (from a cost perspective) is ETFs listed in London which have higher transaction costs, involve FX conversion and (last time I checked) were not convenient to trade on line. In effect, by precluding difficult to access overseas products and high cost actively managed funds, I am currently limited to the following:

1. ETFs listed in Hong Kong which track indices linked to Hong Kong, China, Taiwan, India, and Russia. ETFs linked to the US, Japan, Asia and Europe seldom trade;

2. Equities and REITs listed in Hong Kong, Australia and New Zealand;

3. An ETF linked to a basket of commodities;

4. A limited range of high grade bonds denominated in HK$, US$, Euro, NZ$ and RMB. The spreads on these products are enormous;

5. ELDs over large cap Hong Kong stocks;

6. CLDs over a number of currency pairs;

7. Paper gold, silver and platinum;

8. Cash and bank deposits;

9. Real estate in Hong Kong.

In terms of reducing portfolio risk by diversifying among asset classes which have negative or low correlation, my options are a bit limited. Currencies by reason of being a zero sum game should have a low or negative correlation with equity markets over a period of time. ELDs offer some diversification benefits - especially if I write them sufficiently far out of the money. Bonds offer a degree of diversification benefit but the spreads effectively mean that holding to maturity is necessary to overcome those spreads. Commodities and real estate have shown themselves to be positively correlated with equities. Cash is a safe haven during downturns but a wealth destroyer the rest of the time.

In effect, I have concluded that the best I can realistically do in terms of managing the risks of having a portfolio of assets which are positively correlated are:

1. invest predominantly with a focus on income streams (dividends, interest, premiums, rent). If income is coming in then I should be less concerned about fluctuations in the value of the asset;

2. time the market. Invest aggressively when valuations are cheap and conservatively when valuations are expensive. In practice, this means buy equities when the market is down and shift to low yielding out of the money ELDs when the market is high;

3. consider using the commodity ETF, CLDs and paper metals more than at present.

Given that the range of ETFs listed in Hong Kong is expanding, I should keep an eye on these products with a view to achieving better diversification as and when additional products have enough liquidity to trade.

I am effectively concluding that modern portfolio theory is a good thing for me at this stage of my journey towards financial independence but that the obstacles to implementing that theory necessitate taking a different approach.

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