Prudent Risk Diversification: Challenges to and Solutions for Short-Duration Investors

Abstract

A common misconception of risk diversification may be that additional credits automatically result in a safer portfolio. Today however, one of the primary challenges in developing a successful diversification strategy for short duration investors is a smaller pool of eligible investments. A mad dash into European financial debt, certain sovereign debt, municipal debt, and bank deposits by money funds and other investors provides evidence that some diversification strategies may actually increase, rather than decrease, risk. A fundamental credit evaluation process remains the best weapon against credit risk and it should form the basis of any successful diversification strategy. When the eligible investment pool shrinks, investors may be better off increasing concentration in higher quality credits than blindly diversifying into highly rated, but unfamiliar, names.

Introduction

The benefits of risk diversification are so widely accepted these days that almost every investment policy statement (IPS), including those for short-duration portfolios, requires diversification targets for specific investments. However, investors may not be aware that the pool of eligible investments has shrunk dramatically in recent years. Diversification for diversification’s sake, thus, may increase credit risk and reduce portfolio performance. This is especially true for short-duration portfolios in which an increased probability of default may overshadow the incremental yield gained when adding peripheral credits to satisfy diversification targets.
In last month’s newsletter, we attempted to summarize Eurozone bank credit exposures in U.S. prime money funds. One observation we made from the datasets was that the largest exposures tended to be found within large and systemically important entities. This phenomenon illustrates the trade-off that managers of money funds and separate accounts may often have to make: concentration in large and stronger names versus diversification into smaller, less liquid, and perhaps less credit-worthy names. Our commentary traces the sources of the current dilemma and some possible responses to this issue. Ultimately, we hope to establish that individual credit selection should be at the core of the decision process.
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