As not even professional asset managers can be certain about how the capital markets will actually perform, diversification is both a respected obligation and one of the most difficult challenges when it comes to managing a portfolio. By applying a professional approach to diversification, risk can be significantly reduced: a firm objective for both an overall portfolio and equity portfolios.
Diversification in the overall portfolio
PARSUMO Capital is of the firm belief that the diversification effect of a mixed portfolio changes over time as the market conditions to which the portfolio is exposed also change.
Unstable correlations
The correlation between various asset classes makes diversification possible in the first place. However, it is anything but constant, which is why the market does not always allow for an equal level of diversification. In this respect, it is important to consider that the diversification effect in a mixed portfolio is not constant and may change significantly over time. There are therefore phases in which diversification is vital, but extremely difficult to achieve. By contrast, there are periods in which it is easy to diversify, but where this is not a priority.
Diversification for equity portfolios
Target selected unsystematic risks
In an active equity mandate, unsystematic risks (stock risks) must be carefully selected. Common active approaches evaluate stocks on the basis of just a few criteria. The selection of the supposedly best stocks results in portfolios that frequently do not stand up to closer scrutiny. The consequence of such a sub-optimal selection is unsystematic risk that is usually unrewarded. Furthermore, the stock risks taken have to be balanced and ensure adequate diversification. In inefficient markets, these carefully selected unsystematic risks lead to the desired outperformance.
Avoid sector, currency and country risks
The key advantage of PARSUMO Capital’s equity portfolios is the neutral sector, country and currency positioning relative to the benchmark. Traditional stock selection often leads to being overweight in certain sectors, countries or currencies, as the corresponding stocks seem to be cheap. This leads to good diversification within the preferred sector or country, but, overall, to inadequate portfolio diversification across all sectors and countries. PARSUMO Capital’s equity portfolios avoid such imbalances and add value (alpha) purely through stock selection.
Diversification of PARSUMO’s equity portfolios
PARSUMO Capital achieves optimal diversification by giving equal weighting to selected stocks within the size components (small, mid and large caps) and within the sector and country allocations. This ensures better diversification and the investor only assumes stock risks that promise added value in terms of returns. In efficient markets, we limit ourselves to the use of ETFs to achieve optimal diversification.
Diversification summary
A sensible approach to diversification pursues the following goals:
- Effective diversification protects against significant losses without forgoing too many opportunities when market conditions are advantageous.
- Risk management and diversification are applied taking into consideration the prospective risk conditions of the market.
- Risk management is particularly focused on diversification when market conditions least allow for this effect.
A professional diversification strategy – within the context of the overall portfolio – therefore ensures that the risks entered into can be expected to translate into optimum returns, both in periods when diversification is extremely difficult to achieve and during periods in which diversification may reduce returns.
Within the context of an equity portfolio, PARSUMO Capital believes that the strict limitation to well-selected and targeted stock risks offers the best prospects of success.
Achieving optimal, risk-adjusted returns is a demandig task and requires experienced portfolio managers.
