Funds that don’t really diversify

Doing my daily reading today, I stumbled across an interesting piece about Australian mutual funds that invest in global markets, and how they perform. The article addresses some of the tactics used by these large funds, which seem to have the common theme of investing in strong companies with emerging markets. Global index investing was another theme, which seems like an overly simplified portfolio idea, but then again, I’ve never worked at a mutual fund. I also believe the article was misleading, referring to ‘global investing’ as a solid diversification tool. It seems to me that any strategy based on a simplistic “buy and hold a percentage of this and that” (yes, I’m going to trade mark that phrase) can never ever be truly diversified.

My definition of diversified is offsetting risk by investing in a broad range of securities using multiple timeframes. I’ve talked about the folly of diversifying by sector, and at a later date I’ll probably go into more depth about this point, but for now, diversifying using a buy and hold strategy isn’t really possible beyond a slight systematic risk offset. The reason is, all global markets are interconnected. Capital isn’t going to continue to flow into emerging markets at the same rate once the big guys develop a bearish outlook. There’s a correlation between economies, and an even large correlation in how members of the worldwide financial sector think. In short, if markets such as the NYSE, ASX, FTSE, and the DAX all drop considerably, changing the sentiment from bullish to bearish, its unlikely one can continue to beat interest rate even if the entire portfolio is invested with a careful global bias.

Just to make myself clear, I have no problems with a global stock portfolio, looking to make higher alpha returns on one’s portfolio. Diversifying can also reduce risk of a major event crippling an economy, such as a large scale terrorist attack. It’s dangerous to imply, however, that a global portfolio protects against losses or substandard returns. If safety of your money is a concern, you should be looking at other options, such as bonds, REITs, and even investing in a small hedge fund. I would never trust an ‘all long’ fund whose sole strategy for dealing with market turbulence is to be placed in multiple (correlated) markets. But what really set me off about this article:

However, currency effects tend to cancel each other out over the long term, says Morningstar’s head of research, Anthony Serhan. He says fund managers who hedge for currency get it wrong as often as they get it right. Serhan says having exposure to foreign currencies is a further diversifier for long-term Australian shares. He also says the costs of hedging can be expensive.

“Cancel each other out over the long run”? I suppose the dot com bubble has been canceled out after only 7 years, why did I ever think I needed to hedge back in 2000! Yes, these people could be managing your money.