EDHEC-Risk Institute cautions institutional investors on portfolio diversification

A new publication from EDHEC-Risk Institute is encouraging institutional investors to look at the effectiveness of their portfolio diversification.

CACEIS supports the research chair on “New Frontiers in Risk Assessment and Performance Reporting” which produced the report.
Before the financial crisis, pension funds were insufficiently diversified, with concentration in a small number of asset categories. Since the crisis of 2007, there has been a genuine trend towards investment in new asset classes and categories in order to diversify, but that does not mean that the diversification is effective.
The study, Improved Risk Reporting with Factor-Based Diversification Measures, examined the 1,000 largest US pension funds as of 30 September 2002, 30 September 2007 and 30 September 2012.
The research introduces new diversification measures based on the concept of risk allocation rather than the concept of asset allocation. The authors’ aim was to measure the correspondence between the appearance of diversification (the effective number of classes or constituents, or ENC) and the reality of diversification (the effective number of bets, or ENB), which measures the actual number of independent risky bets taken by institutional investors. Risk-adjusted performance is measured more effectively by using ENB.
Increasing the number of asset classes or categories without taking the inter-relations between their risks into account does not provide any real gain in terms, first, of diversification, and then of performance.

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