A risk institute is cautioning institutional investors to look carefully at the effectiveness of their portfolio diversification.
In a new publication entitled “Improved Risk Reporting with Factor-Based Diversification Measures,” EDHEC-Risk Institute encourages institutional investors to think on how best to diversify their funds.
“Before the financial crisis, pension funds were insufficiently diversified, with concentration in a small number of asset categories. Since the crisis of 2007, there has been a genuine trend towards investment in new asset classes and categories in order to diversify, but that does not mean that the diversification is effective,” said a release from CACEIS, which supported the research that was produced.
The study examined the 1,000 largest US pension funds as of 30 September 2002, 30 September 2007 and 30 September 2012.
The research introduces new diversification measures based on the concept of risk allocation rather than the concept of asset allocation. The authors’ aim was to measure the correspondence between the appearance of diversification (the effective number of classes or constituents, or ENC) and the reality of diversification (the effective number of bets, or ENB), which measures the actual number of independent risky bets taken by institutional investors. Risk-adjusted performance is measured more effectively by using ENB.
“Increasing the number of asset classes or categories without taking the inter-relations between their risks into account does not provide any real gain in terms, first, of diversification, and then of performance,” said CACEIS.
