Thursday, February 27, 2014

Markowitz attacks hedge fund diversification claims

From Risk:

Nobel prize winner Harry Markowitz says alternative investments may not deliver the diversification benefits sought by investors
Harry Markowitz, one of the pioneers of modern portfolio theory and 1990 Nobel prize winner, has claimed alternative investments such as hedge funds rarely offer the diversification benefits sought by their investors.

"The people selling these products claim they have higher expected returns and lower correlations and volatilities than traditional investments. But if you dig deeper, you'll find that isn't really true in most cases," says Markowitz, professor of finance at the University of California in San Diego.

Markowitz's comments came after a BNY Mellon study found nearly 80% of institutional investors have an allocation to alternative investments, compared to 40% in 2009. Investors also expect to raise their allocations to virtually every category of alternative investment over the next five years. Asked why they were allocating to alternatives, 69% of respondents cited the diversification benefits.

"Investors clearly believe alternatives can enhance diversification. They expect to achieve a good return, but the real reason for investing in alternatives is to increase portfolio diversification, so that if there is another market event – which everyone is convinced there will be – they will be better protected on the downside," says Debra Baker, head of BNY Mellon's global risk solutions group.

The idea behind modern portfolio theory is to combine assets with low correlations to reduce the variance, or riskiness, of a portfolio. Alternative investments are thought of as effective diversifiers of risk because of their low correlations to traditional assets. But that benefit is offset by the higher average volatility of alternatives, according to Markowitz. "The fact is alternatives tend to be more volatile investments, which makes them poor diversifiers," he says....MORE