Why the World’s Largest Pension Fund Needs to Get Real about Portfolio Diversification

The good news about portfolio diversification is that it is an act of pure self interest in pursuit of the preservation of capital. The bad news is that most portfolios are likely not to go far enough in their diversification attempts, even if they look good on paper. 

Last week Hiromichi Mizuno, chief investment officer of the world’s largest pension fund, told a conference in California that global markets have become so synchronized that money managers risk losing on every front.

 

Hiromichi Mizuno

 

“Conventional wisdom of portfolio diversification is when we lose money in equity we make a profit in fixed income,” Mizuno told the board of the California Public Employees’ Retirement System, the largest U.S. pension. “But we lost in every single asset classes and lost in the currency translation as well. It never happened in the past.”

The synchronization Mizuno talks about is not a one off event.  On 15th September it will be 11 years since Lehman Brothers brought the financial system to its knees for the very same reason.  The issue is one of design.   Because the overwhelming majority of financial products are derivatives whose value depends upon the value of other financial products the financial system has evolved into a system of value-dependencies.  This inter-dependence means that if a bank like Lehman Brothers fails the solvency of other intuitions is compromised because the value of the assets they hold depended upon the assets held by Lehman Brothers.   Like a sweater unravelling the dependency ricochets throughout the system.  Japan’s $1.5 trillion Government Pension Investment Fund is simply experiencing these dependencies in its negative return profile.

 

Lehman Brothers

 

In the context of these dependencies that make up today’s financial system, the problem that Mizuno and almost every portfolio manager faces is that there is likely to be very little genuine diversification in their portfolio.  Instead the portfolio is likely to be made up of assets whose value depends upon other assets and institutional counterparties.  It does not matter if these assets are bonds, equities, emerging markets, hedge funds, ETF’s or currency.  In reality they are facets of just one system.  Diversification has disappeared, not because diversification is not the bedrock of sound investing, but because the financial system has morphed into this singularity. 

Genuine Portfolio Diversification (GPD) accepts the reality of a unified fiat financial system.  No matter what assets are in a portfolio, if they are part of the fiat system they are, for the purposes of diversification, treated as just one asset.  Therefore, if an investment manager wants genuine diversification they have to look outside the fiat system for their assets.  These are few but obvious.  They include property, owned outright and commodities such as precious metals, again owned outright. 

Interestingly, under this more rigorous definition of diversification, digital currencies such as Monero, Litecoin and Bitcoin do diversify as their value does not depend upon the fiat system. 

To improve the offering available to the investor, the digital infrastructure of the blockchain has also evolved a new asset class called Self-Managed Investments (SMI’s).  As a form of digital hedge fund the express purpose of SMI’s it to provide hedge-fund like returns outside the fiat system. 

Self-interest is a powerful motivational force.  It has to be as it takes a lot for an investor to realise the diversification strategy they may have been pursuing for decades is no diversification at all. If the wake-up call is heard there is also the more practical issue of the relative scarcity of assets that meet the GPD criteria.  Bitcoin has only 21 million coins.  Gold production only increases supply on average by 2 per cent a year.   Like passengers on the Titanic, some portfolio managers may be left wondering why there are so few lifeboats as they watch China-US relations sink to new lows.