One of the free lunches in life is diversification. When putting together a portfolio of funds, one needs to consider the investment style, philosophy and process of the manager running the fund. This translates into how the fund is likely to perform through the cycle. The benefit of understanding this allows one to mix and match funds that behave differently at different points in the market cycle.
We refer to the relationship between the performance of the funds as their relative correlation. A lower correlation between zero and one indicates that the funds move in different directions more frequently and a correlation close to one suggests they perform positively simultaneously and negatively simultaneously.
Another statistic that is particularly relevant to investors who withdraw some of their capital is the maximum drawdown on a fund. Withdrawing from the fund can result in locking in a maximum loss if the liquidity requirement unfortunately coincides with the bottom of the performance cycle.
There is a way to reduce one’s maximum drawdown as we will illustrate below. Take four different funds: a Flexible Fund, a High Equity Multi-Asset fund, an Africa Bond Fund and a Hedge Fund. These
four funds have the correlation relationship between them as illustrated by the matrix below.
What is vital is the result when these funds are combined into an equally weighted series. The combined series of returns results in a return that will sit somewhere between the four underlying funds, depending on how they are weighted over time. This is logical and something generally understood.
What is less understood and expected is that the maximum drawdown of the combined funds can be less than any of the underlying funds. In essence, the maximum drawdown of the whole is greater (or less negative) than the sum of the parts.
This phenomenon is illustrated in the chart on the right where the four portfolios’ maximum drawdowns are shown by the lines, and the combination of the four funds is shown by the grey shadow area.
The maximum drawdown or worst loss an investor could have experienced in the case of investing in each individual fund and the combination is summarised in order below. For context of how tough the pandemic market crash was, we have also included the FTSE JSE Capped SWIX index to represent the SA equity market maximum drawdown.
As can be seen, the combined portfolio has a max drawdown of at least 1% less than any of the underlying funds. This is due to the low correlation and high diversification benefits between the various funds.
The result is that even at the worst point in the market cycle, withdrawing from your combined investment would not be as painful as disinvesting from a single strategy. All these investment strategies used for this example are available and actively managed by Laurium Capital.