[R-SIG-Finance] making sense of 100's of funds

BBands bbands at gmail.com
Tue Aug 21 21:46:38 CEST 2007

On 8/21/07, Sylvain BARTHELEMY <barth at tac-financial.com> wrote:
> John,
> >> The benefits of diversification are a myth, or, more properly, a
> >> nightmare. (They did exist once upon a time, but that was long, long
> >> ago.)
> No, I don't agree with that. The benefits of diversification are not easy to
> quantify and maybe less important than in the past, but I would not say that
> it is a myth or even a nightmare.
> It is true that financial markets are more and more integrated and that
> contagion is usually observed during financial crises, especially on
> emerging markets. But the impact of large events and crises are less
> important on well diversified portfolio (geographically, different
> instruments, different sectors,...).

In practice that doesn't seem to be the case. In this cycle in
particular most things were sold off with a maddening similarity. The
following was sent to me off list:

I fully agree with you....the myth of diversification is great for
academic purposes.  We run a portfolio of hedge funds and try to look at
correlations of our managers in a portfolio...but the pattern you
describe below is exactly what we see...detract from performance in an
up market and as correlations go to 1, don't offer enough protection in
a down market.  The only time it may work is a nontrending market, in
which case it may be better to have a diversified portfolio?

> I don't think that diversification disappear, but that the way to construct
> a diversified portfolio changes over time, as financial markets change.

The problem is that the reversals are so rapid that is may well be
impossible to dynamically adjust.

> >> In today's markets on the way up diversification averages down
> >> returns, while on the way down diversification offers no benefits as
> >> correlations converge on one.
> Yes, maybe the correlation should converge on one as financial markets are
> more and more integrated.
> But the fact is that correlation measures usually show very unstable
> process, and they can changes very rapidly from uncorrelated one to high
> correlated markets, especially during crises (see correlations between
> emerging markets during the 97 crisis). Then, all this is very different
> from a smooth trend toward less diversification gains and more correlation
> between world markets.

My point is that in today's markets diversification dumbs down a
portfolio during expansions--I'll grant that in some cases that there
may be some pickup in risk-adjusted returns. However, when it comes to
decline such as the one we just saw, diversification offers cold
comfort to the practitioner as correlations converge. Unfortunately it
is exactly in these times that the benefits of diversification are
most counted on and most missed.

> >> Having said that, I'll crawl into my bunker and await the incoming.
> Don't crawl into your bunker, it is an interesting topic, and not only for
> banks and portfolio managers. I would be interested to know more about your
> ideas on that.

I've found that when tackling shibboleths, a bunker offers some comfort.

To paraphrase one of Dirk's signatures.

Hell, there are no rules here, we are trying to make money.

John Bollinger, CFA, CMT

If you advance far enough, you arrive at the beginning.

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