The value of deliberate risk-taking in a world of diminishing diversification

BY OLWETHU NOTSHE Portfolio Manager, Sentio Capital

For benchmark-cognisant fund managers, the choice of a benchmark is an important step on the path to good risk-adjusted returns for clients. Suffice to say, portfolio managers have a better chance of outperformance when there is a diversified opportunity set in which they can participate.

However, since 2013, the rally in industrial stocks like Naspers has resulted in a phenomenon where diversification has been disappearing in indices such as the SWIX. At times, Naspers and Prosus have made up more than 27% of the index. Most prudent investor principles and risk budgeting frameworks would find it difficult to allocate almost a third of a portfolio to essentially one underlying entity, i.e. Tencent.

In a world where almost 30% of an index relates predominantly to one entity, levels of concentration (as measured by a metric called the Herfindahl-Hirschman Index) have more than doubled since 2013. To what extent does diversifying your portfolio really reduce the risk profile of your portfolio, if you are a benchmark-cognisant investor with a concentrated benchmark?

Guarding your portfolio against extreme losses through diversifying your stock holdings is a long held and widely accepted approach in risk management. A commonly used approach is to construct portfolios focusing on the correlations and volatilities of the underlying equities. However, this approach often neglects more subtle (i.e. higher order) statistical effects and other nuances, such as the concentration of stocks in the benchmark, that can lead to extreme losses for clients.

Good risk management has become crucial in the investment process

More sophisticated methods can be used to measure the diversification inherent in a benchmark. The Portfolio Diversification Index (PDI) is a metric that measures the number of independent sources of risk in a portfolio and combines the concepts of volatility, correlation and concentration into one coherent number. The PDI reveals that the SWIX was considerably more diversified in 2005, with nine independent sources of risk, as compared to today where there are currently only four! This is due to higher market volatility and increased stock correlations (both due to economic uncertainties arising from COVID-19), and the Naspers/Tencent concentration problem in the SWIX. Having only four independent sources of risk in a portfolio is sub-optimal and requires managers to exhibit high degrees of skill in stock selection and portfolio construction. Therefore, good risk management has become crucial in the investment process, as an unintended accumulation of risks can result in large drawdowns in a portfolio, and undesirable outcomes for clients. At Sentio, we do not advocate for diversification for the sake of it. Our approach ensures that all risks that are taken in our portfolios are done deliberately and consciously. Our risk management framework ensures our portfolios maximise risk-adjusted returns for our clients, and that great care is taken in ensuring that a possible negative shock in anyone of these sources of risk is controlled.