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February 23, 2009 12:00 AM

Exploring diversification and leverage

Or, learning lessons from the market meltdown

Louis S. Harvey
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    It may be an understatement to say that you’ve been on the hot seat during the past several weeks. The massive market meltdown of 2008 raises a fundamental question about the reliance on diversification to mitigate risk in an investment strategy.

    Diversification has been the cornerstone of good investment practices. Diversification is the basis for modern portfolio theory. Diversification is part of fiduciary duties under current regulation. Congress wrote diversification requirements into the Pension Protection Act of 2006. This commitment to diversification has been given the unquestioned credence of a law of nature.

    But what if all sectors implode simultaneously?

    This is a question that needs to be answered, because a repeat of 2008 is entirely plausible at some point in the future. Fiduciaries and all investment experts now have knowledge of this threat that was not available before. As such, it is the fiduciaries’ and investment experts’ duty to act prudently based on the information available at the time. The defense that “I could not be expected to have known” might be acceptable for the meltdown in client assets in the recent past, but will not hold water if we experience another meltdown in the future.

    What strategy can a prudent person use?

    The major lesson we can learn from the market crisis is that leverage can lift and lower the world, and this is a law of nature. The natural law of leverage should now take its place alongside diversification as a critical investment strategy. Giving leverage its appropriate emphasis will require a massive effort to monitor leverage in the private sector, in government and in all international markets.

    In the private sector, true leverage includes the multiplier effect of assets that are themselves leveraged. For example, true leverage in portfolios would include the portfolio’s own short positions and margins as well as the debt of all the investments held. In the case of government debt, leverage is based on all revenue available to fund its obligations. The evaluation of leverage as debt in relation to balance sheet assets or equity that is in current practice should be reviewed and possibly extended to include the ability to service the debt and an examination of the leverage in the underlying assets and equity.

    Monitoring leverage can begin with fiduciaries and investment experts requiring issuers to compute and disclose their true leverage. Such disclosure looks past the balance sheet and includes special purpose vehicles, legal entities created by corporations for off-balance-sheet financing or other specific activity. What if issuers refuse? The threat of divestment will ensure quick cooperation!

    The next step is to incorporate leverage into investment decisions. Leverage should be added to computer models that screen investments and those making asset allocation recommendations. This means dramatic revision to the investment decision process. For example, if the market as a whole is too highly leveraged, diversification cannot be expected to mitigate that form of risk. What is the next step?

    These thoughts are far from being fully developed, but exploring the ideas would set a good path on the way to make sure the hot seat never catches you off guard again.

    Louis S. Harvey is president of DALBAR Inc., Boston

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