Macro diversification: How do investors diversify risk?

“Geopolitics does matter and how to navigate geopolitical events on a portfolio is challenging,” argues Tom Clarke, partner and portfolio manager at William Blair speaking at the Fiduciary Investors Symposium at Rhodes House, Oxford University.

In a session dedicated to macro strategies for investors to best navigate today’s complex investment universe and diversify risk, Clarke argues that “hiding” from geopolitical events “isn’t diversifying: what we want is insight.”

Clarke’s advice is for investors to see geopolitical risk as “strategic players” trying to produce their own outcomes in a series of bargaining exercises.

“Who are the players that matter, what do they want and will they achieve it?” he asks. “What matters is whether geopolitical risk prices will be pushed, or pulled away from valuation,” he says.

Applying this analysis to the crisis in the Eurozone, he believes diversified Eurozone equities “are attractive.” However the Euro – and it is always important to consider a jurisdiction’s currency and asset differently since “currencies go in different direction to assets” – is unattractive. “When it comes to the Euro my view is that it is unattractive and overvalued,” he says.

Staffan Sevon, head of tactical asset allocation and hedge fund investments at Finland’s €29-billion ($39-billion) Ilmarinen fund has a similar drill down approach to macro risk.

“Understanding the drivers of the market is so important. You can’t just have an opinion on US equities – you have to look at how that asset class should return relative to others,” he says.

But diversifying geopolitical and macro risk is difficult. “How do markets react during war?” he asks, pointing out that equities don’t necessarily fall during a conflict. Similarly, he argues that if Greece leaves the Euro it could be seen as strengthening Europe on one hand but also very damaging if investors flee the continent.

Studying correlations between asset classes can offer insight, although he warns “when you look at correlations be careful how you measure them and select a time frame that is relevant to you.” Sevon believes that global equity is by far the strongest connecting point, adding: “If you don’t have an idea about equities, you don’t have an idea about other assets. Equities tend to control others – there is a strong, positive correlation.”

But the breakdown in correlations and their usefulness in flagging macro risk was an issue raised by Peter Wallach, head of the United Kingdom’s Merseyside Pension Fund, a £5.75 billion open, defined-benefit local authority scheme.

“It worries me that correlations between bonds and equities has broken down in the recent past,” he says. “We need a better way to diversify and manage risk going forward,” he says.