Diversification vs. Concertation: central banks and the reshaped architecture of financial markets.
Updated: Mar 16, 2021
For centuries, explorations through the seas opened new geographic horizons and commercial routes that helped humankind to grow and expand. In the modern age of sailing expeditions, the Spanish empire was an early realiser that, to increase their chances of success, a good hedge against the roughness of the oceans would have been to send out a fleet, rather than one standalone ship, as also Columbus got assigned not one but three caravels. Later on, the East India Company pioneered not only diversification of risk through fleets, but also by incorporating their ventures into limited liability companies, so to avoid the unlimited legal and economic responsibility of their partners in case of wrecking, loss or robbery.
Interestingly enough, the aforementioned historical facts seem to be the blueprints of two universally preached financial and portfolio management dogmas: diversification and risk hedging. Diversification states, generally, that an investment portfolio made of multiple and different asset classes (or securities), which have a low-performance correlation between themselves, is far more efficient and less risky than a concentrated portfolio made of similar assets. The second one, risk hedging, relates to the fact that almost any investment position can be partially or wholly hedged against the risk of a loss by “structuring” it, so to have some insurance or protection against an eventual downturn. This can be achieved by purchasing derivative instruments, such as options, or by wrapping the investable asset into an ancillary legal structure, such as a trust or an SPV (Special Purpose Vehicle).
For decades diversification has been a paramount risk tool implemented by any savvy investor, but in the years following the 2008 Global Financial Crisis something happened: around the world, all major central banks (CBs) started to grow their balance sheets by purchasing securities (at first government’s and then also corporate’s) as part of their quantitative easing programs. This practice was already known from the past, albeit never before in such an enormous proportion, and the ultimate message to the markets was that Central Banks were going to save the day “whatever it takes”, so to avoid our global economy, and the financial markets, to fall into a deep depression. As a consequence of this, investors started to get smart and decided to push their risk appetite upwards, perceiving that the central banks were spoiling the risk barometer downwards. Bonds and equities rallied, with growth stocks overpowering value ones as interest rates plunged and cash became the cheapest commodity of all - exception made only for Chinese restaurants in London (possibly).
However, the most game-changing effect of CBs risk tapering action wasn’t necessarily a roaring bull market. In fact, and instead, it was to correlate the price movements of asset classes that were before perceived as decorrelated. We then started seeing bonds behaving like equities and equities moving alongside bonds, with the consequence of spreading a great deal of confusion between market participants. Today, after almost 12 years, we reached a new historical high of the longest bull market in history. All asset classes seem to be an array of dependants single points ling on the same curve of risk, which shifts upwards and downwards accordingly to the press conference given by any relevant CBs chair - lucky they still refrain from tweeting, at least for the time being…
Hence, on the back of all this seemingly new-norm of the public markets, investors today are more and more looking into private markets through Private Equity, Private Debt, Trade Finance and Venture Capital, as clear sign that they are progressively willing to trade-off liquidity for diversification - hoping also to achieve higher returns. The ultimate result is that most portfolio diversification is chased outside public markets, as often today many investors have the perception that Treasuries move accordingly with Apples (…both fruits and stocks!).
This article has been written by Tancredi Cordero. Tancredi is the Founder & CEO of Kuros Associates.