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The objective of portfolio diversification is to reduce risk without diluting returns. Although there are limits on the extent to which risks can be diversified away, most investment portfolios are not well diversified and operate far from the efficient frontier. It is generally accepted that in order to earn superior long term returns an investment portfolio should be primarily invested in equities. The price of this anticipated superior long term return is acceptance of a degree of inherent equity volatility or "market risk " relating to the process of value creation in the economy. All equity investments, however, also contain embedded currency and interest rate risks, and a well designed investment portfolio will therefore not only contain an international mix of equities but will also contain a well chosen mix of currency and fixed interest investments (short as well as long positions) to diversify risk and to reduce overall volatility. A portfolio can, however, easily become inefficient as a result of one or more factors including insufficient international equity diversification or an inappropriate mix of currency and interest rate positions, which merely serve to exacerbate volatility. The problem of maintaining an efficient portfolio is compounded by the continually changing relationships between financial markets. To learn more about the design factors contributing to the low efficiency of some typical UK balanced funds, download the HedgeAnalysis UK balanced fund report. The purpose of the HedgeAnalysis application is firstly to provide a tool to measure the extent to which a portfolio is efficiently diversified and secondly to facilitate the formulation of hedging strategy to enhance the expected risk-return characteristics of the chosen investment portfolio. HedgeAnalysis works within the framework of the efficient markets hypothesis. No attempt is made to predict individual investment returns. The objective is simply to utilise observed relationships between different types of investment to achieve efficient diversification and to reduce volatility while preserving the real level of long term returns expected from equity investment. The use of observed relationships between investments is complicated by estimating errors which inevitably arise when measuring volatile quantities. Conventional linear program models fail to take account of these errors and produce results which are often simply incorrect. For more background, see a recent HedgeAnalysis review of the limitations of traditional linear programmes. HedgeAnalysis is unique amongst portfolio optimisers in using risk eigenvector decomposition and filtering techniques to avoid excessive reliance on historic volatilities as measured, when identifying those portfolios which can in the future be expected to display below average volatilities for a given level of expected return. To learn more about designing optimised portfolios download the Optimally Hedged Global Index Fund discussion document. HedgeAnalysis methodology can be applied equally to both conventional portfolios and portfolios containing hedge funds, providing details of hedge fund investment profiles are available to the user. For more background on this see a recent HedgeAnalysis discussion note on the application of modern portfolio theory to hedge funds. Since the correlation and volatility relationships between investments change over time, it is important for any systematic diversification and hedging strategy to reflect up to date estimates of the various relationships. The HedgeAnalysis application makes use of Datasets which are derived from datasets updated daily by the independent RiskMetrics service and made available over the Internet. A subscription to the HedgeAnalysis service provides access to regularly updated Datasets as well as support and upgrades of the HedgeAnalysis application. Last modified: |
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