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1.
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Definition
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Diversification in finance involves spreading investments around
into many types of investments, including stocks, mutual funds,
bonds, and cash. Money can also be diversified into different mutual
fund investment strategies, including growth funds, balanced funds,
index funds, small cap, large cap, and sector-specific funds.
Geographic diversification involves a mixture of domestic and
international investments.
Diversification reduces the risk of a portfolio. It does not
necessarily reduce the returns. This is why diversification is
referred to as the only free lunch in finance.
Other Resources:
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4Insurance.com:
Spreading investments among different types of securities and
various companies in different fields.
More…
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Capital Market Risk
Advisors:
An investment strategy that involves buying a variety of
investment instruments that are not highly correlated to each
other in order to reduce the risk of a portfolio.
More…
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Vector 2000:
The acquisition of a group of assets in which returns on the
assets are not directly related over time.
More…
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Ent Federal:
Diversification is the concept of spreading your money
across different investment types and investments having various
levels of risk.
More…
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Citibank:
Diversification is the investment strategy of putting your money
into a number of different investments in order to reduce
overall Investment Risk.
More…
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2.
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Examples, Types, or
Variations
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Horizontal Diversification
Horizontal diversification is when you diversify between
same-type investments. It can be a broad diversification (like
investing in several NASDAQ companies) or more narrowed
(investing in several stocks of the same branch or sector).
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Vertical Diversification
Vertical Diversification is investing between different types of
investment. Again, it can be a very broad diversification, like
diversifying between bonds and stocks, or a more narrowed
diversification, like diversifying between stocks of different
branches.
While horizontal diversification lessens the risk of just
investing all-in-one, a vertical diversification goes far beyond
that and insures you against market and/or economical changes.
Furthermore, the broader the diversification the lesser the
risk.
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Super-diversification
The
highest degree of diversification occurs when institutional
asset class funds are used to construct a financial portfolio.
The term was first introduced in 'Wealth Without Worry' by Jim
Whiddon and Lance Alston (Brown Books, 2005) who apply the
fundamental academic research of Eugene Fama and Professor
Kenneth French. See also: diversification, efficient market
hypothesis and market portfolio theory.
A super-diversified, asset class portfolio holds somewhere
between 10,000 and 12,000 securities through a smaller number of
institutional asset class funds. See also: dimensional fund
advisors.
Other Resources:
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Guy Bower:
Types of Diversification: Diversification across
assets within a class, diversification across time, and
diversification across asset classes.
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3.
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Formula
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Diversification can be quantified as the intra-portfolio
correlation. This is a statistical measurement from negative one to
one that measures the degree to which the various assets in a
portfolio can be expected to perform in a similar fashion or not.
Other Resources:
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Wikipedia:
Portfolio
balance occurs as the sum of all intra-portfolio correlations
approaches negative one. Diversification is thus defined as the
intra-portfolio correlation or, more specifically, the weighted
average intra-portfolio correlation. Maximum diversification
occurs when the intra-portfolio correlation is minimized.
Intra-portfolio correlation may be an effective risk management
measurement. The computation may be expressed as:
Where Q
is the intra-portfolio correlation, Xi
is the fraction invested in asset i,
Xj is the
fraction invested in asset j, Pij
is the correlation between assets i and j, and
n is the number of different assets.
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4.
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Related Terms
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Asset Allocation
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Intra-Portfolio Correlation
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Systematic Risk
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Modern Portfolio Theory
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Volatility
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5.
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As
Used in the Hedge Fund World
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Other Resources:
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EDHEC-Risk:
Hedge funds are often thought of as being high-risk
investments and many investors in the past have shied away from
them for fear of making large losses. However, over the recent
years, hedge funds have generally substantially outperformed
equities, with much lower volatility.
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6.
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Applications
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Other Resources:
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Wikipedia:
Diversification can be quantified as the intra-portfolio
correlation. This is a
statistical measurement from negative one to one that
measures the degree to which the various
assets
in a portfolio can be expected to perform in a similar fashion
or not.
|
Intra-portfolio correlation |
Percent
of diversifiable risk eliminated |
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1 |
0% |
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.75 |
12.5% |
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.50 |
25% |
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.25 |
37.5% |
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0 |
50% |
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-.25 |
62.5% |
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-.50 |
75% |
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-.75 |
87.5%
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-1 |
100% |
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7.
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Misused
& Abused
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Some confuse
diversification with hedging, but unlike hedging (wherein the risks
have negative correlations – the risks taken are offset),
diversification has no correlation between risks.
Other Resources:
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Abacus:
Often, alternative investment fund and account managers have
total trading authority over their funds or accounts; the use of
a single advisor applying generally similar trading programs
could mean lack of diversification and, consequently, higher
risk.
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8.
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Additional Sources of Information
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Books
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News
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Scholarly Papers
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Back to Terms
| HEDGE FUND RISK AND OTHER
DISCLOSURES |
Hedge funds, including fund of funds (“Hedge
Funds”), are unregistered private investment partnerships, funds or
pools that may invest and trade in many different markets,
strategies and instruments (including securities, non-securities and
derivatives) and are NOT subject to the same regulatory requirements
as mutual funds, including mutual fund requirements to provide
certain periodic and standardized pricing and valuation information
to investors. There are substantial risks in investing in Hedge
Funds. Persons interested in investing in Hedge Funds should
carefully note the following:
- Hedge Funds represent speculative investments and involve a
high degree of risk. An investor could lose all or a substantial
portion of his/her investment. Investors must have the financial
ability, sophistication/experience and willingness to bear the
risks of an investment in a Hedge Fund.
- An investment in a Hedge Fund should be discretionary capital
set aside strictly for speculative purposes.
- An investment in a Hedge Fund is not suitable or desirable for
all investors. Only qualified eligible investors may invest in
Hedge Funds.
- Hedge Fund offering documents are not reviewed or approved by
federal or state regulators
- Hedge Funds may be leveraged (including highly leveraged) and
a Hedge Fund’s performance may be volatile
- An investment in a Hedge Fund may be illiquid and there may be
significant restrictions on transferring interests in a Hedge
Fund. There is no secondary market for an investor’s investment in
a Hedge Fund and none is expected to develop.
- A Hedge Fund may have little or no operating history or
performance and may use hypothetical or pro forma performance
which may not reflect actual trading done by the manager or
advisor and should be reviewed carefully. Investors should not
place undue reliance on hypothetical or pro forma performance.
- A Hedge Fund’s manager or advisor has total trading authority
over the Hedge Fund.
- A Hedge Fund may use a single advisor or employ a single
strategy, which could mean a lack of diversification and higher
risk.
- A Hedge Fund (for example, a fund of funds) and its managers
or advisors may rely on the trading expertise and experience of
third-party managers or advisors, the identity of which may not be
disclosed to investors
- A Hedge Fund may involve a complex tax structure, which should
be reviewed carefully.
- A Hedge Fund may involve structures or strategies that may
cause delays in important tax information being sent to investors.
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underlying investments (including sub-funds in a fund of funds
structure) to investors. If this is the case, there will be no way
for an investor to monitor the specific investments made by the
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sub-fund investments are consistent with the Hedge Fund’s
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- A Hedge Fund may execute a substantial portion of trades on
foreign exchanges or over-the-counter markets, which could mean
higher risk.
- A Hedge Fund’s fees and expenses-which may be substantial
regardless of any positive return- will offset the Hedge Fund’s
trading profits. In a fund of funds or similar structure, fees are
generally charged at the fund as well as the sub-fund levels;
therefore fees charged investors will be higher that those charged
if the investor invested directly in the sub-fund(s).
- Hedge Funds are not required to provide periodic pricing or
valuation information to investors.
- Hedge Funds and their managers/advisors may be subject to
various conflicts of interest.
The above general
summary is not a complete list of the risks and other important
disclosures involved in investing in Hedge Funds and, with respect
to any particular Hedge Fund, is subject to the more complete and
specific disclosures contained in such Hedge Fund’s respective
offering documents. Before making any investment, an investor should
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investment in the Hedge Fund is suitable for the investor in light
of the investor’s investment objectives, financial circumstances and
tax situation.
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