The downturn has destroyed the myth of diversification

<strong>MOORAD CHOUDHRY</strong><br />HEAD OF TREASURY, EUROPE ARAB BANK<br /><br />IN THE 1950s the economists Harry Markowitz, Franco Modigliani, Merton Miller and William Sharpe formulated their ideas on portfolio theory and corporate finance, which became the foundation of modern finance and fund management. These chaps were serious heavyweight thinkers, and rewarded with Nobel prizes.<br /><br />In the 21st century however, it&rsquo;s time for a rethink. Because the fact is, finance theory no longer applies. Two of the central tenets of modern portfolio theory &ndash; diversification and liquid markets &ndash; have been shown to be inaccurate during the crisis.<br /><br />The year 2008 was an annus atrocitas for financial markets. No investor was protected against the downfall in asset prices. Even the stars of the last decade, the hedge fund wizards of Greenwich, Connecticut, who promised investment portfolios to be immune against correction by adding &ldquo;portable alpha&rdquo; to their portfolios, had to admit defeat. Every major asset class suffered losses. <br /><br /><strong>DESTROYING VALUE</strong><br />What the 2007-2008 credit crunch taught us was that diversification is a myth. A cornerstone of modern finance, the Modern Portfolio Theory (MPT), did not withstand the test during the market crisis. And it can be demonstrated that in a bear market diversification to hedge or spread risk destroys value rather than creates it, because it merely magnifies the existing risk exposure for no reward.<br /><br />An important element in Markowitz&rsquo;s theory is correlation. In his paper he argued that the risk of a portfolio could be reduced, and the expected rate of return increased, when assets with dissimilar price movements are combined. Such diversification reduces risk only with assets whose prices move inversely with each other. In other words the lower the correlation, the better for the risk-reward profile on the efficient frontier.<br /><br />But looking at the table on the right, which shows the Credit Suisse Tremont Hedge Fund Index for 2008, we see clearly that this is not the case. All strategies (except for &ldquo;dedicated shorts&rdquo; and &ldquo;managed futures&rdquo;) returned a negative performance for 2008. Dedicated shorts and managed futures are pure directional plays, like betting in a casino, and would always perform positive in the current environment. Such strategies cannot be said to represent the application of MPT.<br /><br />The fact is, MPT and the diversification argument only really work in a bull market. In a bear market, or in any period of negative sentiment, all asset prices and markets go down. And in times of crisis, as we have observed recently, correlation between asset classes is practically unity.<br /><br />It does not matter what industry, country or level of managerial expertise is being considered, all prices go down and all credit spreads widen in a market correction. In this crisis, everyone has lost money. Banks, hedge funds, volatility traders, private equity, long-short investors, and traditional long-only fund managers have all registered losses.<br /><br />On paper, diversification sounds like a great thing but where modern portfolio theory suffers the greatest weakness is in its assumption that in every market correlation is below 1.00. What we have observed over the last five years, whether it is managed on the basis of fundamental factors, momentum, arbitrage or any other rationale, is that everyone tends to end up on the same side of the trade at the same time.<br /><br />Believers in portfolio theory are convinced that (for instance) alternative investments are somehow negatively correlated with basic equities. During 2007-08 they have learnt the hard way that this is simply not true.<br /><br />The same argument applies to banks that diversified by branching out and operating globally. The rationale was that by moving into different geographical regions, the banks spread and diversified risk. In fact this just magnified risk across economies so that when the credit crunch came it hit them everywhere.<br /><br />While the ultimate global bank, HSBC, appears to have weathered the storm fairly well, possibly due more to its vast size than its geographical dispersion, some of the largest hits, relatively, have been at global players such as Citibank, RBS and UBS. <br /><br /><strong>GENERATE ALPHA</strong><br />Only a minority of fund managers ever consistently outperform the index or benchmark. Given that they charge their clients a fee, those that fail to do so are failing to create value. Most investors would be better off simply tracking their benchmark index. To continue to market an ability to generate alpha, to claim that one can outperform the market over anything other than the very short-term is something that should be viewed with some scepticism.<br /><br />Markowitz&rsquo;s MPT had much merit over the last 30 years. It was the basis for an investment and banking model that generated significant returns from the 1980s onwards. However in a severe bear market the model has been seen to be flawed, and contributed to the development of a banking business model that suffered large losses. The assumptions on which it is based clearly prove that a paradigm shift in economics needs to take place that modifies or completely replaces MPT. That is a task for academic economists. Senior management in banks has a different objective: to review their business and modify their portfolio diversification model, whether it applies to geographical region or business lines.