In case you were wondering . . . Part 2 - Diversity and the Hedge (1/11/2012)

“A portfolio is a collection of assets and the debt incurred to acquire them . . . A portfolio should have purpose and include diverse investments. Diversity takes advantage of the opposing natures of investment types to hedge and balance risk. “

The key word is “hedge” - a bet against the dominant strategy. The classic example from Finance 101 is equity (corporate stock) vs. cash. Cash deposits are loans to the bank – hence the interest payment. In a bull (strong) market, equities are more attractive than debt and yields decline. In a bear (weak) market, investors seek alternatives including debt and yields rise. (Yield = the stated interest rate +/- the effect of any discount/premium on face value at purchase).

So, portfolio design includes cash and debt instruments to buffer the effect when equities go soft. The diversity protects in two ways. The first is through “absolute return” – interest income + increased market value. The second is by the liquid nature of cash and equivalents. If funds are required, there is an alternative to selling undervalued assets or paying a premium to exit structured, illiquid investments.

Most portfolios include Cash, Fixed Income, Alternative Investments, and Equity. Usually, equity is the dominant strategy. As described above, the other investments are selected to improve the absolute return, smooth volatility and provide adequate liquidity. This concept is called “asset allocation”. Quantitative models define optimal allocations (the “efficient frontier”) based on the purpose of the portfolio and risk appetite of the investor. Portfolio design requires thorough knowledge of financial markets and theory; an ability to predict; and discipline. Over time, the portfolio will drift from the allocation plan due to the differing strengths of the investment categories. At least annually, portfolios are re-balanced – the strong sold to acquire the weak. This may seem counter-intuitive but it is necessary. In portfolio management, vigorous due diligence, ruthless selection and commitment to the plan are vital.

Diversity exists within a category. All equities don’t walk in lockstep. Performance can be governed by the size of the companies – large, mid, small and micro capitalization; by maturity; by style – growth, income and value; by industry; by ownership – public vs. private; and by location – domestic, foreign and emerging. Several years ago, the Alternative Investment Category was measured by thirteen different benchmarks. Bonds are contracts and the negotiable qualities can change sensitivity to the equity markets from none to complete. Where there is diversity, there is a possible hedge.

So far, I’ve described Diversity as a strategy. But it can be a tactic, as well. The strategy might be to take a long position in a stock. But if the market is very volatile, you might want some insurance against failure. So, you go short and sell a block of the stock. You can keep the proceeds and invest elsewhere or buy back in to reduce basis. You’ve just become a hedge fund. If you use a “put” to implement the short position, you’re into derivatives. This tactic gives up profit from the long play but eases the effects of failure.

Inadequate diversity can be dangerous. European bonds have been whipsawing the equity markets. Why? The risks of default and remedy were knowable when the bonds were issued. The WSJ of 11/14 offered a glimmer of understanding. There may be concern about the adequacy of hedges.

When a financial institution makes a large play, it bets against the strategy and employs complex hedges including insurance, hard collateral and derivatives. The size of the hedge varies with the risk assessment. The institution may not be required to identify individual hedges, only the overall net exposure. Now, if you were the manager of a large fund investing in one of these financial institutions, you might be worried. Just look at MF Global. A drop in the value of the bonds it held triggered a margin call it could not meet. The lender placed the loan in technical default and MF Global was on the block. Where was the hedge?