How investors can avoid the pitfalls of diversification in portfolios

Erik Vynckier, Non-Executive Director, Foresters Friendly Society, explains how diversification has affected private markets - and whether you can diversify too much.

Insurance Investor Editorposted on Monday, May 30, 2022

Erik Vynckier, Non-Executive Director, Foresters Friendly Society.

Diversification is overextended and greater focus needs to be paid to hedging, portfolio insurance, and other tools instead, say several industry leaders.

In a recent Clear Path Analysis panel discussion, Erik Vynckier, Non-Executive Director, Foresters Friendly Society, explained how the practice can be a double-edged sword in protecting your business from economic shocks.

Vynckier spoke in Clear Path Analysis’s Insurance Asset Management - Europe 2022 report, which featured several market experts from insurance groups including Aviva, New Re., Foresters Friendly Society, Cattolica Assicurazioni, exploring the new post-pandemic market and what strategies he thinks fellow insurers should have in place.

“You have your asset allocation, and you take that hit on the equity side, as there’s no escaping it, and there is not much escaping widening spreads in the credit market, so you take that hit too.”

According to Vynckier, there were multiple examples of where too much complexity was being added to certain portfolios.

“There are two sides to this question, there is the immediate market response that expressed itself in the liquid markets, in equity, and above all credit markets, but also in sovereign debt,” said Vynckier. “You have your asset allocation, and you take that hit on the equity side, as there’s no escaping it, and there is not much escaping widening spreads in the credit market, so you take that hit too.” Having a diversified portfolio helps you limit the hit, he added, although equity and credit investments go the same way.

A paper from abrdn backed up his views and said that diversification would # open your portfolio as economically sensitive assets suffer simultaneously during recessions. “Illiquid assets can be marked down in price when liquidity becomes scarce. Less economically sensitive assets can provide genuine diversification but may come with other risks. A dynamic approach to asset allocation can reduce risk but increases reliance on manager skill,” it explained.

“If you survived this mark-to-market and took advantage of buying or buying on the dip in the credit markets in this second movement where the policy response kicked in, then the only thing that we benefitted from is that we had started diversifying our portfolio away from public markets."

Vynckier said the second impact that is slightly delayed, which is the impact of the policy response. “In this case, it was a massive expansion of quantitative easing. This controversially pumped up the equity markets,” he said. “If you survived this mark-to-market and took advantage of buying or buying on the dip in the credit markets in this second movement where the policy response kicked in, then the only thing that we benefitted from is that we had started diversifying our portfolio away from public markets into things like trade finance, equity infrastructure, and private debt, such as mid-market finance.”

There is a wider picture to this too – the UK government released a paper around consultation in March 2022, on potential ways to Facilitate investment in illiquid assets, which is related to the phasing out of Defined Contributions.

"But the question is whether the markets have actually been rational here. On the face of it, why on earth were public traded securities riskier than the private instruments that we held? Why did they actually do better during the pandemic?”

“At first I thought, how on earth is this going to pan out for these highly leveraged companies?” said Vynckier. “Will we see defaults in our invoicing, and so forth, but actually we didn’t. This part of the portfolio was never mark-to-market and held well, so in a sense diversification sort of helped us.”

“But the question,” he continued, “Is whether the markets have actually been rational here. On the face of it, why on earth were public traded securities riskier than the private instruments that we held? Why did they actually do better during the pandemic?”

Vynckier says he can’t “rationally explain why we did well”.

One reason could be quantitative easing (QE), which was seen massively in both the US and Europe – The Federal Reserve purchased massive amounts of debt securities, a key tool it employed during the Great Recession.  “It was as much the secondary impact from QE, and this sort of economic stimulus, that helped us more than the portfolio construction per se,” he said.

To learn more about this issue and others facing insurers, read our report Insurance Asset Management Europe here.

 

Please Sign In or Register to leave a Comment.