The key to achieving greater diversification in a portfolio is not to think in terms of asset classes but instead focus on risk factors, according to Franklin Templeton Solutions’ Matthias Hoppe.
“When you do traditional asset allocation and just decide between equities and bonds, you miss hidden risks in the portfolio, as certain asset classes have risk factors in common. Therefore, especially during periods of market stress, correlations tend to rise and you do not get the diversification that you thought you would have in a portfolio.”
The senior vice-president portfolio manager mainly looks after multi-asset funds for European clients but also a product for South African pension funds and an emerging market product for a Mexican bank.
Specific risks
In total, the European business manages about $2.2bn (£1.5bn, €1.9bn) in multi-asset products, with the group Franklin Templeton Solutions notching up about $40bn in assets under management.
An economist by background, Hoppe has been running portfolios at Franklin Templeton since 2008, after joining from a smaller German asset manager. Before that, he was at a German bank working on the equity derivatives side of the business.
As a group, Franklin Templeton Solutions also manages more traditional asset allocation portfolios, where it has a top-down approach and then allocates to asset classes, rather than picking stocks or bonds.
When that added layer of risk assessment comes into play, Hoppe says he drills down into the specific risk contributions of the investments in the portfolio.
He illustrates this by citing a traditional multi-asset or balanced portfolio with 60% of the allocation in equities and 40% in bonds, where he says more than 85% of the risk will be driven by the equity component.
“The asset classes can be broken down into building blocks and they explain the majority of the asset’s risk and return characteristics. The problem is that diverse asset classes can have unexpectedly high correlations. That means poor diversification.”
One easy-to-understand risk factor is currency, where a euro-based investor with allocations to US equity and US bonds faces a risk factor with the US dollar.
“There are other risk factors that would affect the portfolio, and what we are trying to do is to diversify across those factors.”
For each investment under consideration, the process involves first classifying it in one of four categories that it has defined, namely growth, defensive, stable and opportunistic.
Classification
“Growth is everything that will benefit from global growth, and equities are a natural component of that growth category. For instance, emerging market bonds, for us, would fall under the growth category.
“The defensive bucket, by contrast, is everything that offers potential protection against significant losses from a major market downturn. It can be a hedge that we put in place on a more tactical basis, for instance buying a put option on the S&P 500 or strategies that would offer us protection, thanks to their low or negative correlations.”
In the past, the third category he identifies, stable, would typically have been a money market investment but, as he points out, money-market yields are currently negative in the eurozone and other regions.
