Diversifying at home

Investments in developed market equity is not a guarantee of attractive risk-return opportunities.

Some asset management firms offer products that help investors take exposure to equity markets in developed countries. Portfolio diversification is one factor that typically drives investors to invest beyond their home market. It is, however, a moot point if investments in developed markets offer attractive risk-return trade-offs to Indian investors. So why not explore if investors can gainfully diversify within the home market?

This article explains why exposure to developed markets is not necessarily attractive. It also discusses how investors can use the core-satellite framework to diversify risk within the home market.

Developed markets do not offer enough alpha-generating opportunities in the traditional asset class, especially stocks, compared with the Indian market. It essentially means that the portfolio managers may not have enough opportunities to outperform the appropriate benchmark index. This is a primary reason for the significant increase in demand for alternative strategies such as private equity and hedge funds and for alternative assets such as commodities. Besides, return from beta exposure in developed markets is not higher compared with the Indian market.

There is, hence, no compelling reason for Indian investors to buy assets in developed markets based on return objectives. If risk minimisation is the reason, investors need to draw their attention to the sub-prime crisis of 2008. During times of global crisis, all markets tank, though the degree of decline varies.

Investing in developed markets to reduce risk during “normal” market conditions does not appear attractive. The reason is that if the Indian economy remains an attractive investment opportunity for foreigners, asset prices here are likely to claw back most of the “normal” losses faster than those in developed markets.

Besides, investors can strategically invest within home market to diversify their asset price risk. The question is how?

Home diversification

Take the core-satellite portfolio. This portfolio framework is based on the rationale that it is cost-effective and behaviourally optimal to separate returns into index return (beta) and excess return over the index (alpha). The core portfolio has a passive beta exposure while the satellite portfolio has active alpha exposure. The beta exposure has a longer investment horizon than the alpha.

Now, consider the sub-prime crisis. Suppose an investor had equity exposure in her core and satellite portfolios. Depending on her risk tolerance level, the investor would have taken large losses in her satellite portfolio during 2008, but not on her core portfolio.

This is because the core portfolio is primarily rebalanced to align with the strategic asset allocation while the satellite portfolio has to manage large short-term volatility and beat the market.

Further, investors would typically hold their core portfolio if asset prices decline during “normal” market conditions. Why? If the Indian economy is as vibrant as it has been touted to be, investors are likely to remain optimistic. And that could typically lead to bounce-back in asset prices.

Thus, the core portfolio by precluding the need to trade actively reduces the risk contributed by the actively-managed satellite portfolio. Horizon diversification — difference in investment horizon between core and satellite — inherently minimises portfolio risk.

This argument presented here does not mean that investors should not consider exposure beyond their home market. It is, however, important to consider global exposure based on sector weightings instead of country weightings, especially when it involves investing in developed markets.

Suppose a portfolio manager identifies banking as an outperforming sector in the next three years. The portfolio ought to be created by picking the best banking stocks across the world without being constrained by the country weighting. And such global exposure would be taken to enhance returns, not to minimise risk; for diversification fails to minimise risk due to correlation asymmetry — correlations among assets may be weak during normal market conditions but become strong during market breakdowns.

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