Institutional investors first to drop diversification

Institutional investors appear to be leading the charge in downgrading diversification across traditional asset classes as a strategy to protect against tail-risk events.

A new report from State Street Global Investors showed that while most investor types, including family offices, consultants and private banks, had increased their use of diversification strategies to mitigate tail-risk, such use among institutional investors in Europe and the US had dropped from 89 per cent before the GFC to 67 per cent in June/July 2012.

The report said that although institutional investors had been the greatest supporters of diversification strategies, they may now be the first to recognise and accept them as less effective due to increasing correlations between traditional asset classes. 

State Street found that 47 per cent of respondents believed traditional diversification strategies had been disproved as providing insulation against tail-risk events, despite many investors increased use. It said the contradiction showed a need for new risk-aversion strategies.

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The use of direct hedging to manage tail-risk events increased from 36 per cent to 44 per cent among institutional investors, but the reverse was true of consultants, who had decreased direct hedging strategies from 45 per cent to 31 per cent.

Institutional investors had also increased their use of managed volatility equity strategies and single-strategy hedge fund allocations to replace diversification strategies, State Street said.

An across-the-board drop in fund of hedge fund allocations reflected the asset class's poor performance in 2008, it said, with the strategy declining 39 per cent to 30 per cent.

According to the report, investors said the main barriers to allocating to tail-risk/protection strategies were: the liquidity of the underlying investment (46 per cent), regulation (54 per cent), and risk-aversion (49 per cent).

Cost was cited as another factor affecting protection strategies (42 per cent) where even traditional assets were seen as expensive due to low returns.

Almost three quarters of respondents believed they were better protected due to changing strategic asset allocations, and 71 per cent thought a tail-risk event was looming in the next 12 months. Almost three quarters agreed that future events would be more severe.

Despite this, investors thought tail-risk expectations were under-estimated among their peers - 51 per cent believed investors misjudged the frequency and severity of events.