Diversification according to Investec

January 26, 2010

According to most experts, diversification in its simplest form is a risk management technique that involves mixing a wide variety of investments within a portfolio. Diversification should then allow for the same portfolio return with reduced risk.

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. However, as Investec correctly notes in recent article, structured products are not an asset class, they are simply another way for an investor to access a specific asset class in a pre-defined and sometimes, a more efficient way. Because most structured products offer some form of capital protection the pay-off profile is more difficult to include in a traditional risk-weighted portfolio. Investec feels its more appropriate for an adviser to adapt his investment approach to include structured products given the choice available, as opposed to trying to shoehorn a client into possibly a less efficient portfolio. This can provide a more pragmatic approach to portfolio construction.

Using structured products within a client’s portfolio can be much simpler than many advisers believe. Investec says focus on the equity element of a portfolio as the majority of retail structured products are linked to an equity index of some form. 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 by incorporating a variety of structures within the given equity component. While many structured products only issue retail products linked to major indices, e.g. the FTSE100 and the S&P 500, to provide a core holding that gives a balanced and diversified exposure to world GDP growth. This is still valuable for diversification purposes because companies that comprise these indices derive more than two thirds of their revenues from outside their home country. Furthermore, globalization has diluted some of the benefits of spreading equity investments geographically with correlations between the major equity markets currently upwards of some 75%.

The real skill when diversifying assets is finding a robust and efficient method to access uncorrelated returns. Structured products can be very useful in providing a method to diversify.