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Managing Risk Through Diversification.

By John Dietz - Email Editor

Date : 15-Aug-2007

Dear Valued Reader,

If you have been nervous over the financial markets, you're certainly not alone. The U.S. dollar, sub-prime mortgages and general market sentiment is probably at the top of your worry list. This article attempts to bring home the real live workings of asset classes, asset allocation, diversification and how they directly affect your portfolio.

In an increasingly complex environment, each of us is the Chief Financial Officer (CFO) of our own franchise or personal balance sheet, not unlike the CFO of General Electric Company (GE). Prudently managing our affairs and respective personal balance sheet demands a growing knowledge of the global marketplace both financially and legally.

For General Electric, the objective of the CFO is to execute strategies that best position the company to protect, preserve and build shareholder equity or the value of GE stock. Similarly, as individual CFOs, our unwavering focus should be on understanding and executing those strategies that best position you and I to protect, preserve and build personal wealth. An essential component for success for both GE and the individual CFO is true diversification in all aspects of our work.

Diversification can come in many forms such as, but not limited to: asset class, geography, jurisdiction, and currency. In this vein, a core risk for many investment portfolios, regardless of holding structure, is flawed diversification.

As an example, from a pure investment perspective, one widely held belief is that owning several dozen stocks, across a variety of industries, is sufficient to dampen the impact of a dramatic decline in one or a few sectors. Yet many apparently diversified portfolios are extremely sensitive to one or more underlying variables. Furthermore, large companies, while often thought of in terms of “quality or blue chips,” by their very nature have significant business relationships; they are often co-dependent. As a consequence, traditional modes of diversification or thinking can actually concentrate rather than reduce risk.

A seemingly well diversified portfolio of the late 90s might have held WorldCom, JP Morgan Chase, Cisco, and Equity Office Properties, all leading companies of entirely different industries. The ultimate collapse of WorldCom rippled through each of these holdings due to their extensive business relationships or “co-dependence.” WorldCom was a favored customer of JP Morgan Chase's lending arm and a major contributor to the growth of Cisco. All three companies were sizeable tenants of Equity Office Properties, a major provider of leased office space. This seemingly well diversified portfolio was actually exposed to a single common variable: the continued growth and financial health of WorldCom.

When you decide to become the CFO of your assets you will begin to understand and seek ways to avoid the potential risks and volatility that investing can present, your attention will almost always be diverted to the international or global markets. The idea is that the global marketplace can effectively dampen volatility and risk based on greater diversification. In general, the idea is spot on target. However, it is the execution of the strategy that is often wrought with potholes and flaws.

For many individual CFOs the most accessible route to global diversification is through mutual funds oriented to international exposure or holdings. Interestingly, the large majority of these fund offerings are investing the fund's assets in American Depository Receipts (ADRs) rather than the ordinary shares available for investment in the global market. An American Depository Receipt is a certificate issued by a bank in the United States representing a certain amount of shares of a foreign company on a foreign exchange. They can be traded on American exchanges just as a domestic stock can be; they make foreign investment much easier. However, while ADRs may make investing in foreign markets easier, the question is does the approach accomplish our objective of executing those strategies that best position our personal balance sheet to optimally protect, preserve and build wealth?

Consider some basic statistics on the subject: There are less than 200 European ADRs traded on the New York Stock Exchange versus over 6,000 stocks available for investment in Europe alone. In Asia, Australia and South America the ratio of ADRs to ordinary investment shares is even smaller than Europe. Moreover, ADRs tend to represent large, multinational companies with a significant exposure to the U.S. market and a high level of “co-dependence.”

Part of the ease of investment in ADRs also stems from the fact that the shares all trade in U.S. dollars versus the local currency in which the business or investment is actually domiciled. So rather than gaining greater global exposure and diversifying into to the Swiss Franc or Euro for a portion of one's personal balance sheet as General Electric does for much of its balance sheet, the individual CFO's assets are all still invested in U.S. dollars.

While foreign governments, pensions, endowments, Fortune 500 companies and affluent individuals globally have been diversifying their balance sheets with respect to currency for generations, U.S. institutions and individuals have long been U.S. dollar investment centric. As the world market capitalization for non-U.S. stocks and investment now exceeds 50% and growing, diversification and risk management will be rooted in gaining full, unrestricted access to these markets. Currency diversification will be an essential component of the risk management equation and strategy going forward. This level of diversification beyond U.S. dollar and U.S. market events, best positions each of us for preservation and growth of personal wealth in both, the short and the long term.

Until next time,

John

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