IN PRINT ARCHIVE CIR Summer 2008
By Kevin Kneafsey, Global Co-Head, Strategic Solutions Group, Barclays Global Investors
In investing, there are four demons of illusion that significantly reduce the efficiency with which portfolios generate returns. The demons act to limit the power of diversification. Change any one of these and you will significantly improve the ability of your portfolio to deliver its potential. They are called demons of illusion because they detract from performance and obscure how we look at and think about portfolios. The fix for each of these demons requires a change of perspective. Sometimes we fall into a way of looking at something and according to that perception what we do is correct. Then something happens and suddenly we see the same thing differently and, seen in this new light, our original approach seems sub-optimal. This is the case with the demons.
The first demon has us focus on the asset part of the portfolio while ignoring the liability portfolio. Considering the liability as assets held short and hedging the risks associated with these short positions prevents the distortion brought about by the first demon. With the risks of the liability hedged, one is free to confront the three remaining demons. The second, the demon of capital allocation focus, distorts the perception of diversification by focusing on the capital allocation and thereby masking the underlying economic exposure. A simple and significant step toward reducing this distortion calls for the inclusion of risk allocation information to accompany the capital allocation information.
Too close for comfort
The third demon, the demon of asset class focus, is extremely damaging but less easy to control. This demon is damning because it inserts an opaque layer between how a portfolio is implemented, along asset class lines, and the key tenets of investing: bear risks that are rewarded and employ diversification to manage these risks. The fix for this demon requires us to re-think the investment problem and eliminate the opaque asset class layer and re-focus on the underlying systematic risks and the risk premia they offer. It requires investors to demand investible assets that provide pure exposure to the underlying risk premia. It requires money managers to research and build investible products that deliver pure systematic risk exposure.
Finally, the fourth demon, the demon of leverage, challenges us to re-examine our portfolios in terms of implicit and explicit leverage. Prohibiting explicit leverage, while turning a blind eye to implicit leverage, encourages the use of implicit leverage and the construction of portfolios that are less well-diversified and, consequently, less efficient. Recognizing the economic exposures and prudently deploying explicit and implicit leverage to well-diversified portfolios defeats this demon.
These four demons grow from the same seed. They each work to limit investors’ ability to harness the power of diversification and obscure the focus on the investment problem. By obscuring the economic realities, the systematic risk exposures in the portfolio, they draw attention away from the key drivers of the portfolio performance. The good news is that these demons can be tamed. It requires that we change our perspective to expose the demons and see past their illusions. With a newfound clarity, we can then address the investment problem with our most powerful tools, the basics of investing and the power of diversification.