Investors and managers may not escape market risks if they all rush toward the same exits
One of the most basic lessons in investing is that having a diversified portfolio lets investors spread and minimize their risks. But what if the investors in the market aren’t diverse in their diversification?
“When investment managers create diversity within their funds, chances are they will look similar to other managers also aiming for diversity,” wrote Wall Street Journal columnist Paul Davies. “And that means they could all succumb to the same ills.”
As an example, Davies noted how banks grew and diversified across borders and business lines following the 2008 financial crisis, only to end up with the same exposures and encounter the same problems simultaneously. The trend toward securitization also saw a market of mortgage-backed securities that collapsed because while each deal was diversified, too many mortgages were too similar.
“This idea is alive and well in today’s market for risky leveraged loans, where securitization creates so-called collateralized loan obligations, which buy 60% of loans,” Davies noted. While loans and collateralized loan obligations have seen a boom in issuance, the markets are still concentrated. Citing data from Fitch Ratings, he said CLOs often have similar portfolios and the biggest loans are very commonly held.
“On average, US CLO managers have roughly one-third of all borrowers in common, while in Europe about half of borrowers are common,” Davies wrote. The upshot for CLO investors is that investing with multiple managers doesn’t necessarily preclude the possibility that they’re taking on the same underlying risks.
He added that greater ubiquity of deals rated single-B and below, which are more prone to downgrades and defaults, would likely mean more widespread losses in the event of a downturn, even for CLO investors who think they’re well-diversified.
Related stories:
Ninepoint announces flow-through partnership
Why portfolio managers must avoid risk dilution
