Binary Capital Investment Management

Binary Capital Investment Management Investment thinking Diversification thoughts: new thinking Long-termism shapes our relationships and our investments. as of December 2020 binarycapital.co.uk Diworsification Summary In portfolio management, diversification is a tool, not a goal. A tool to be used alongside other investment tools Authored by: and objectives to generate consistent returns for clients over the long-term. We discuss diversification considerations for long-term global asset allocators, and why diversification does not always benefit the end clients. We try to understand why this is. We closely look at how we at Binary Capital see diversification and implement such a strategy in all our portfolios. This paper covers our diversification thinking. Saftar Sarwar Chief Investment Officer Diversification To spread the risk of investment holdings, so that the volatility, risk and returns from a group of assets, be it equities, fixed income and investment funds, or other investments can be successfully Amir Miah managed. Junior Portfolio Manager Capital at risk. Introduction Diversification has been a fundamental principle of finance since modern financial theory and practice took hold, and it has been described as the only free lunch in finance. (H MARKOWITZ, 1952). Diversification is the strategy of spreading risk by investing in a range of investments which whilst individually risky, when they become part of a portfolio of investments the overall risk of that portfolio diminishes, returns are smoother and more optimal for the risk undertaken. In this paper we explore diversification as well as the possibility and the very high probability that there could be over-diversification in the investment industry. This can be due to many factors, factors that are often very controllable and should be well understood. We will explore this from a portfolio management perspective as well as multi-fund, multi-asset solutions – solutions that are very common in the investment and wealth management industry, so called Discretionary Fund Management (DFM) solutions. Initially described in Peter Lynch’s book, “One Up On Wall Street” (1989) as a corporate specific problem, the term “Diworsification” has developed into a term used to describe inefficient diversification relating to an entire investment portfolio, i.e., worse diversification, not better. In essence generating lower investment returns from diversifying too much, too broad, too randomly. Owning too many investments can confuse, increase investment cost, add layers of unnecessary complexity and require undue due diligence and potentially lead to below average risk-adjusted returns. The issue we will explore is why do UK wealth managers buy so many investments for their clients? Surely owning the best performing, most optimal investments is better than a broader group of investments. In areas of portfolio management, particularly in the DFM world, there are elements of poor diversification and poor portfolio management practice generally. We will explore this in some detail in this paper. We also suggest coherent ideas that are implementable for liquid investment portfolios that are suitable for all client types in most client circumstances. We discuss the following a. Portfolio diversification with asset classes b. Diversification within equity portfolios c. Building diversified investment solutions d. A sensible and consistent approach to diversification a. Portfolio diversification with asset classes Modern portfolios The topic is broad in nature, so to remain relevant to the subject matter we briefly cover some key points for consideration when thinking about portfolio diversification with and within asset classes. Very important to have core diversification in portfolios A portfolio should be built with quality investment positions. Diversification (or spreading risk) is important but not extensively so. The idea of risk-adjusted returns (Sharpe ratios) stemming from the work of Markowitz, is important for understanding and managing elements of risk, however that analysis is often backward looking. It is not a good predictor of future risk/return behavior, and only looks at risk/diversification effects from a simplistic geographical returns’ perspective for example. Risk/return optimizers are not forward looking. The focus should be on generating returns consistently into the future. The role of bonds in post-modern portfolios We live in an age that is unlike others for fixed income Figure 1: US and UK 10-year generic government bond yields (1989-2020) investing. Interest rates are low and indeed negative in some parts of the world, for example in Japan, Switzerland, Sweden and Denmark. Bond yields are at low levels, often record lows, making it increasingly difficult to extract value from fixed income. Where does that leave fixed income as an asset class from a diversification point of view? Are there alternatives that can take the place of fixed income, or does it have to be ‘dead’ fixed income? Investors have looked at infrastructure and other assets such as absolute return funds, hedge funds and private Source: Binary Capital, Bloomberg equity to become proxies or alternatives to fixed income portfolios. Often such assets correlate with fixed income, however, some do not and behave as general equity like investments. Absolute return funds have attempted to mimic fixed income type returns often with poor correlations and returns. Global absolute return funds end up failing to produce genuine absolute returns for investors. Future alternatives to fixed income still need to be considered from a diversification, returns and conviction perspective. a. Portfolio diversification with asset classes Correlations of asset classes Nowadays, in times of crisis, correlations move Figure 2: Daily stock-bond correlation (2014- 2020) towards one. Recent examples of this include 0.4 the great financial crisis of 2008 (GFC) and the COVID-19 sell off in Feb/March 2020. There is 0.3 no actual diversification if all assets move in the same direction under periods of stress. It is 0.2 during such periods of significant market stress that we require proper diversification the most. 0.1 We would suggest that the rise of technology 0 in the investment world, program trading and algorithm investing for example, has made real Daily Correlation -0.5/20/2014 1 5/20/2015 5/20/2016 5/20/2017 5/20/2018 5/20/2019 5/20/2020 diversification difficult, and broken down the broader diversified investment models. In light of this close correlation of assets, taking a more -0. 2 long-term approach in order to see over time how the assets will behave is a more optimal -0. 3 solution than looking at short-term correlations Source: Binary Capital, Bloomberg and then acting on such random events. We use ACWI LN for our equity proxy and UKCO LN for our bond proxy. Two contrasting examples of long-term asset allocation models The Equity-Bond Tilt Model A model that splits equity and bonds. The starting point for many wealth advisers, robo-adviser firms and DFM product providers, where 60/40 is defined as a typical Balanced mandate. Often a higher equity allocation is recommended for young individuals (Growth) and a higher bond component for those nearing retirement (Cautious). This is a very common strategy with billions invested in this area. The approach has provided investors with decades of success. It is simple and clear to implement. However, as we witness a changing investment paradigm of low, zero or negative yielding bonds along with the increasing evidence that during times of crisis bonds do not deliver the protection expected, it is worth asking if the 60/40 investment model is still fit for purpose and if a better asset allocation needs to be undertaken to account for the differences in future asset returns – themes as opposed to country allocations? Do we need to be more flexible around such an asset allocation? Should we have better diversification around such a 60/40 model that is genuinely investment led? All areas that we explore and work on very closely as a firm. We believe this strategy needs a version 2.0, we at Binary Capital are actively working on innovative ways of developing such models. The Endowment Model Long-term investors should take note of the very successful US University Endowment Funds (“US Endowment Funds”) such as Harvard and Yale. They have highlighted a diversified multi-asset class investment approach but for the very long-term – often taking a 20 years plus view on such asset classes. The US endowment funds differ in style to traditional stocks and bonds investment strategies through significant exposures to alternative asset classes such as private equity, real estate, commodities and absolute return strategies - often investing over 50% into such asset classes – investing with real conviction. They have consistently achieved attractive annual returns whilst taking moderate risk. Assets such as fixed income are avoided, allowing portfolios to benefit from the increased returns potential offered through an allocation to the assets described above. It is a fairly unique style of investing and most suitable for permanent capital strategies like endowments, foundations and investment trusts. It could be argued that this style of investing is not relevant to retail clients as it involves investing in illiquid assets whilst taking a very long-term view on assets. Furthermore, there are issues associated with creating retail portfolios that are not daily priced and include non-standard assets. In addition, this strategy is also very much a long-term model of investing and again has some limitation for retail and DFM clients. In saying all of the above, some of the best principles of the endowment models need to be carefully analysed and can be implemented. Some of the key principles around concentrated diversification, around best-in-class investment solutions, around ultra long-term thinking, are valid in this investment philosophy and need to be considered seriously in portfolio management. We at Binary Capital are influenced by much of the endowment model thinking around investments.

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