Diversified risky portfolio

moxter

Hello folks - long time lurker, first time poster.

I've been having a bit of fun in the last few months putting some money into a DIY S&S ISA for the first time. It's money I can afford to lose (it'd be frittered away otherwise) and I'm having a bit of fun learning by experience, so I'm experimenting with a pretty high-risk strategy and considering it as a hobby and a learning curve rather than something that needs to make money at this stage.

I have a question about diversification. Does investing in diversified ultra-high-risk funds make sense? If any given high-risk fund expects higher volatility but potentially higher long-term gains, does diversification help overcome the volatility?

For example, could a portfolio that had a substantial element of ultra-high-risk funds (small/micro-cap, emerging markets, renewables) be viable if there was sufficient diversification across markets, industries, etc?

I have a second, related question. For those specialist areas mentioned above, and also for something like (in particular) corporate bonds, what are people's feelings on actively managed funds vs trackers? Is an actively managed strategic bond fund worth paying for, or will a corporate bond tracker suffice?

Thanks in advance. I'll likely have a ton of follow-up questions but I'm picking up a lot of good advice already.

TCA

moxter wrote: »

If any given high-risk fund expects higher volatility but potentially higher long-term gains, does diversification help overcome the volatility?

I would have thought you'd need to diversify with lower risk funds if you want to reduce volatility. Using high risk funds from different sectors would only increase volatility.

ChesterDog

It could work for or against you. That's the nature of several high risks combined. You will only really know with hindsight.

moxter

TCA wrote: »

Using high risk funds from different sectors would only increase volatility.

I'm a little confused - why is this? Is it because in a global downturn all "risky sectors" are more liable to turn south together, potentially with bigger swings than one sector/market on its own?

lozzy1965

A slight change of tack. Given your original post of using this as a learning curve, I would have thought you would invest in individual shares. I'm not a funds person, but I would invest in funds if I wanted to do less work myself (for higher risk investments). Just an alternate view that I'm sure not everyone will agree with

TCA

moxter wrote: »

I'm a little confused - why is this? Is it because in a global downturn all "risky sectors" are more liable to turn south together, potentially with bigger swings than one sector/market on its own?

As ChesterDog said above, it can work both ways. High risk is high risk whether we're in a rising or a falling market. So by picking all high risk funds, you might have the potential for larger gains, but you also have the potential for larger losses.

If you could accurately pick high risk funds that would move in opposite directions to each other in any market conditions, then I see what you're getting at. But I think that would be pretty difficult and even if you could do it successfully, would you not just end up with something in the middle anyway? i.e high returns being cancelled out by large losses, albeit overall volatility reduced?

Edited to confirm I'm no expert on risk and volatility and the above is just my take on it, so you'll hopefully get a more informed response from another poster.

bowlhead99

There are lots of different measures and views on risk and volatility and ways you can use things in a portfolio together to smooth returns, provide protection against extremes and enhance returns by hopping between them as you rebalance from time to time.

For example, a nice balanced portfolio of equities might generally move in the opposite direction as a nice balanced portfolio of bonds. When used in combination, the bonds help to "even out" extremes (peaks and troughs of movement) in the equities. So they help make the whole thing less risky.

But entirely separately from their "inverse correlation" effect, the bonds are inherently less risky in themselves anyway. You are buying a known fixed return which doesn't depend so much on corporate profits from time to time. Which is one of the things driving them to move in an opposite direction as the demand changes when the economy moves from boom to bust.

If you compare a global fund of corporate bonds to a fund of global company equities the latter is more risky but you could use some combination of the two in a good "inverse correlation" way. If you compare a global fund of corporate equities to a single country or specialist sector fund, the latter is more risky but it is not so easy to match them up and get a good "inverse correlation" way.

If you imagine a fund that only invests in UK duvet manufacturers and fan heaters it is going to earn lots of profits in the winter and not do so well in July. It is a high risk fund. If you imagine another fund that only invests in European aircon and ice cream vendors, that is also very high risk and only makes money for half of an economic cycle - but you could put it together with the first fund and reduce overall risk significantly and make money in both July and January.

Now consider another fund that has Australian ice cream sellers and yet another one with New Zealand winter sports gear. They would complement each other but offset their European sectoral counterparts. All four are high risk in their own right but you could find a nice balance that would serve you throughout the whole cycle. Oh, except for when global equities were generally crashing, in which case they would all crash together that year

Obviously this is looking at an "economic cycle" of one year but it's an analogy for sector movements over a longer term. In financial services, the investment banking firms running IPOs make money in the boom times and the corporate insolvency firms do much better in the bad times. On their own, you would be crazy to buy a fund specialising in just one of them unless you were super confident about timing the economy.

So, if you are considering a bunch of high risk funds: biotech /healthcare, generalist technology, emerging markets, energy, natural resources. How well are they correlated? How well are they inversely correlated?

I can tell you from my portfolio tracker that in the last 10-ish weeks, Baillie Gifford Emerging Markets Growth is up 6.7% ; JPM Natural Resources up 6.5% ; Marlborough Microcap down 3.8%. Are they destined to be tied together or locked in opposites as the experience in this short timescale suggests? I doubt it.

I could also look at GLG Technology Equity and Threadneedle European Select over same timescale. One a sector specialist, one a regional opportunities specialist. One gave 1.24%, one 1.26%. Is there something that drives them to give almost exactly matching performances? No, not really!

If you had a portfolio with just these 5 stocks it is probably less volatile than just having one. Because as you can see, in under 3 months, some are well up, some well down and some only averagely up, and the blend is not at the extreme of the high or the low. But a portfolio constructed entirely of these stocks could still lose 50% in a year quite easily and doesn't get you close to a low risk portfolio.

Maybe throw in a large component of strategic bond funds and absolute return funds and a real estate or infrastructure fund or two and other defensive funds and you could get towards some sort of normalcy, but it would be very tricky using those "fun" funds as the initial building blocks.

So bottom line I would say yes you can find some high risk funds that complement each other but it easier said than done, so trying to turn lots of high risk funds into a low risk one is pretty much a pipedream.

hyposmurf

Nice post bowlhead, lost of info that makes sense.

moxter

Utterly brilliant - thanks.

Also, Don's article is a great read.