Strategies for diversification of funds

True diversification is where one finds completely non-correlated assets into a portfolio. The weights of each of these assets could be decided depending upon the timelines, goals and most crucially the risk appetite

Recently, I was interacting with a family who has wealth mostly based on their ancestral properties, at least the large chunk of the income. They approached with a plan to ensure a constant cashflow that wouldn’t get affected by the vagaries of markets and dynamics of life. They don’t want to fund their lifestyle through liquidation of assets, which was what happened during the pandemic shutdown. They were worried if another such situation were to arise, would have a substantial impact on their net-worth.

What was proposed and recommended is a topic for another day but what I would like to highlight as the problem is their extreme concentration of wealth in one asset and how diversification provided the solution. This could be a case with multiple other individuals and/or families where their majority of savings, investments and assets are concentrated in a particular avenue. This is essentially true with retirees whose fortunes vary with the interest rates as their extreme concentration to fixed income in their portfolios.

During outlier situations of war, pandemic, etc., the asset price movements could be trending similar trajectory for a short while but eventually diverse. This non-correlation is what protects the portfolio against greater erosion while also generating returns so that the overall weighted returns remain attractive. The key is to find the right combination that suits the investor’s requirements. It’s easy to show the benefits of diversification on a historical data but to implement to one’s risk tolerance is another.

True diversification is where one finds completely non-correlated assets into a portfolio. The weights of each of these assets could be decided depending upon the timelines, goals and most crucially the risk appetite. The former is not always achieved but we could zero-in on assets whose natural behavior in normal circumstances is distinct to one another. The complexity increases when more than two assets are added where one needs to explore the relativity among each assets sitting together.

This is not a new phenomenon and the modern portfolio theory which is about a seven-decade old addresses it. There were many further iterations to refine it and has many use cases. Though I did take the example of retirees, this line of thought is not only for conservative investors who wouldn’t take risks but same is true for aggressive investors who tend to take higher risk than required.The important factor in all of these is to assess the risk of the asset properly and its return potential, the sweet spot is to achieve the optimal risk-adjusted return.

We usually carry certain notions with each of the asset classes and our expectations stem from that, especially on the future returns. To make a case in point, if we consider the return of equities i.e., from the calendar year 2009 to 2013, the five-year return on NIFTY 50 stands at 17.7 per cent with a standard deviation i.e., risk of 33 per cent. But, during the same period, if one were to assume a mix of debt and derivative strategies (to contain the risk), the returns generated during the period is at 17.7 per cent but with a standard deviation of 24 per cent only. So, a similar return profile with a relatively lower volatility means the second diversified portfolio strategy provides better risk-adjusted returns.

This is what we find in hybrid mutual funds like balanced advantage funds or multi-asset funds where the assets are a mix of debt, equity, derivatives and in the latter additional avenues like commodities, REIT (Real Estate Investment Trusts), InVITs (Investment Trusts), etc. are added. These funds not only achieve good returns but reduce the volatility associated with the investments. So, unlike the conventional acceptance of these funds suitable for moderate risk investors, these are suitable for both the conservative and aggressive investors albeit with varying allocation or proportion.

(The author is a co-founder of “Wealocity”, a wealth management firm and could be reached at knk@wealocity.com)