(January 2006) I’m a firm believer in risk management. That’s a bit like saying “I’m a firm believer in breathing.” We are all risk managers whether we admit it or not. And if that’s the case, I’d rather be more precise about it than less.

The absolute basis of portfolio risk management is diversification. It’s the first topic of Risk 101. But, if you think you’ve heard everything about diversification, think again. In fact, diversification is so obvious, we tend to forget a basic fact: You can easily diversify away specific or idiosyncratic risk — but not systematic risk. This most basic statement is often overlooked, and I would submit needs to be clearly explained to clients. This is not a tired bromide: legal exposure may ensue from under-explaining this.

In a nutshell, “not putting all your eggs in one basket” can basically bring you closer to overall market behaviour, because you’re mixing and matching sectors, capitalizations, corporate lifecycles, and earnings qualities. All good and fine. But in the limit, your increasingly diversified portfolio edges closer and closer to the market portfolio, says William Sharpe (and he’s got the Nobel Prize to prove it’s important).

But if you hold the market portfolio, it means you remain fully exposed to the market cycle and more generally, to macroeconomic factors common to all participants in the economy. That exposure is the systematic risk (borrowing once again Sharpe’s original terminology). As the saying goes, a flowing tide lifts all boats (and conversely for an ebbing one). Unfortunately, that’s the best one portfolio manager or investment advisor can do. It means that a well-diversified portfolio will be subjected to adverse markets, however well diversified it is.

Hence, there’s an inherent limit to the diversification you can attain through astute asset selection. Is this it? Are we condemned to live with market risk, as it were? Not necessarily.

Inasmuch as different countries or regions are swayed by different economic fundamentals, international diversification will mitigate (national) systematic risk. With the foreign content rule now dropped, this is presumably an area of great interest for individual and institutional investors alike.

The other way to reduce market risk is through shorting and, more generally, through stripping out the market effect from the investing process. You may have heard of this as stripping the beta out of the portfolio or separating the alpha and the beta. The beta here means the market effect, market risk or market cycle effect.

Through different financial engineering techniques, typical of hedge funds, a manager can actually mitigate or cancel the market effect and deliver only diversifiable risk — that’s alpha. For instance, market-neutral strategies, as the name implies, would purport to neutralize market influences and focus on pure stock picking, to focus on the relative out-performance of superior corporate management or technical opportunity.

Long/short strategies, by contrast, without offering a permanent state of neutrality to macro factors, will analyze these in the context of the market cycle and take a view (net long or net short) with respect to them.

Actually, this ability to separate alpha from beta raises another issue. Some hedge funds sponsors claim a potential of diversification from investing in their product. I agree — typical hedge fund investments will show correlations with typical portfolios that are significantly lower than one. But is this low correlation due to behaviour that is different from the market (high alpha), or rather due to behaviour that is close to the market’s, but uncorrelated with unsystematic factors (high beta)? It would be interesting to see hedge fund sponsors attribute fund behaviour to alpha and beta from correlation perspective within a typical portfolio.

One intuitive way to do this is to first show correlations with the market (or a proxy such a broad-based market index or weighted average of indices) as well as correlations to a market-neutralized portfolio (the so-called “zero-beta portfolio”). The investor or advisor would then be responsible for interpreting their impact on a specific portfolio. In the end, it’s an easy task to run a correlation computation on Excel between a fund’s returns track record and any given portfolios.

Another fact: compliance is more complicated now. A minimum stance, in my view, is that the investor needs to be told the difference between systematic and unsystematic risk. Typical know-your-client processes and documents ask an investor how they tolerate different levels of portfolio losses.

It would also be of value to ascertain if the investor understands what diversification is: Why different “unrelated” assets are invested in the portfolio, at what rate diversification occurs (i.e., how many different investments are “enough” to diversify the portfolio) and why a portfolio will experience losses even if fully diversified. This is important because diversification is a basic advisor responsibility. More advanced approaches may include a more explicit treatment of alpha and beta, opening the opportunity set to hedge funds, alternative investments, capital-protected products, and the like. But in the end, we are all risk managers now.

This article was originally published in Advisor’s Edge Report. Pierre Saint-Laurent, M.Sc., CFA, CAIA, is president of AssetCounsel Inc. He can be reached at PSL@AssetCounsel.com.

(01/23/06)