Optimise Investments: Balance Portfolios, Manage Risk

In investing, finding the right diversification level is key. While diversifying reduces risk, too many funds can lead to inefficiency. Strike a balance, aligning diversification with your goals and asset size. Effective portfolio construction hinges on sound risk management by investment professionals.

When it comes to constructing an investment portfolio, the ideal level of diversification has been the subject of ongoing debate among experts. Investment funds themselves offer diversification by pooling various investment assets, making it possible to spread your investments across a wide array of ideas. However, there's a fine line between optimal diversification and overloading your portfolio with too many funds. In this article, we'll explore the nuances of diversification and how to strike the right balance.

The Pitfalls of Over-Diversification

While diversification is generally considered a prudent strategy, there are compelling arguments against investing in too many funds. One such argument is that attractive investment opportunities are limited in number, and most capable investment managers often identify the same opportunities. As a result, investment managers within the same strategy tend to construct similar portfolios. Consequently, statistical studies suggest that holding numerous investment funds doesn't significantly reduce portfolio volatility. In fact, it may lead to thinner research into each investment, increasing risk rather than mitigating it.

A more focused portfolio, on the other hand, can be concentrated in high-quality, thoroughly researched funds, potentially reducing risk.

The Perils of Over-Concentration

However, steering away from diversification altogether presents its own set of risks. The investment fund universe is not immune to occasional disasters caused by manager errors or fraud, leading to substantial losses. The least probable outcomes often pose the greatest threats, and while thorough research can help investors avoid such disasters, there are no guarantees.

Adopting a prudent approach, investors should consider avoiding allocating too much to any single investment vehicle. Striking a balance becomes crucial, with the consensus suggesting that investors who allocate less than two percent of their portfolio to a fund may be neglecting their decision-making responsibilities, while those who allocate more than 15 percent might be deemed reckless. Depending on the portfolio's objective, a range of three to seven percent is typically considered reasonable.

Tailoring Diversification to Fund Types

General diversification guidelines should be adjusted based on the types of funds included in a broader portfolio. For instance, merger arbitrage funds tend to employ a relatively homogenous strategy, with similar positions in their portfolios. In this case, diversification can be achieved by using a smaller number of managers. However, convertible arbitrage encompasses a range of distinct styles, making it suitable to invest across a broader spectrum of managers to capture this diversity.

The Challenge of Asset Allocation

A critical factor that impacts diversification is the size of the assets being allocated. Placing substantial sums with certain specialist investment funds, particularly hedge funds, can be challenging due to capacity limitations. Large investors are often faced with a choice between allocating significant amounts to suboptimal managers or spreading their investments widely. Both scenarios present diversification problems.

Conversely, having too few assets can be equally problematic. For instance, the minimum investments for some hedge funds are as high as $1 million, meaning that portfolios with less than $10 million may struggle to achieve proper diversification. In practice, most established hedge fund managers are unwilling to accept investments as small as $1 million.

The Essence of Risk Management

In discussing diversification and portfolio management, it's vital to recognize that investment professionals who specialise in allocating to investment funds are essentially risk managers. Their activities encompass qualitative and quantitative fund analysis, operational due diligence, allocation among investment strategies, and ongoing fund monitoring, all aimed at minimising significant errors and managing risk effectively. Less active investors could use portfolio risk management tools, like Palance, to gain an accurate reflection of aggregate portfolio risks and metrics, usually against a relevant benchmark. Investors are then able to avoid being over (or under) exposed to any single factor, and ultimately could maintain a diversified portfolio that could compound over the long-term.

In conclusion, finding the right balance between diversification and concentration is crucial in constructing a resilient investment portfolio. By considering the type of funds, the size of assets, and the broader risk management perspective, investors can navigate the complex landscape of portfolio construction with confidence.