Deutsche Oppenheim Family Office AG: Diversification During Financial Crisis Showing Dividends for Family Office

Deutsche Oppenheim Family Office AGNo investor could have foreseen the Covid-19 pandemic. Natural disasters are unpredictable events, and uncertainty is one reason for the premium involved in taking risk. Deutsche Oppenheim Family Office AG, one of the leading multi-family offices in the German market, believes investors can prepare for extreme scenarios by diversifying their portfolios.

There are many layers to optimal diversification. That investors should diversify across single stocks, regions and sectors is common knowledge. This eliminates idiosyncratic risk, making portfolios resilient to the performance of individual companies. But what about the performance of the world economy? Which asset classes provide a hedge for global shocks such as 2020?

Bad news first: many asset classes that promise diversification do not provide a hedge. Corporate bonds, for example, are – statistically speaking – a hybrid of equity- and interest-rate risk. The lower the rating, the higher the equity-risk. This is the reason why high-yield bonds mostly correlate with equities and less with interest rates. Similarly, hedge funds are a statistical combination of primary asset classes such as equities, bonds, FX rates, and commodities. Hedge funds like to sell their performance as market-neutral, but often fail in times of financial distress.

“Hedge funds like to sell their performance as market-neutral, but often fail in times of financial distress.”

This is the primary reason that Deutsche Oppenheim Family Office believes none of these asset classes provide a real hedge in the case of a financial crash. From February to March 2020, broadly diversified European and US corporate bond indices lost eight percent in euros, and 12.4 percent in dollars. While corporate bonds reduced the 30 percent loss of a broadly diversified stock index, they did not provide a real hedge. A global high yield bond index was even less effective, by losing 22 percent in dollars. “Unfortunately, most asset classes failed to serve as a hedge: emerging market and convertible bonds also lost around 22 percent, a global commodity index fell by 19 percent, and a diversified hedge fund index lost almost 11 percent in dollar terms,“ says Deutsche Oppenheim’s director of quantitative investment solutions, Vladislav Gounas.

How about government bonds with low-default risk, currencies like the greenback, and commodities such as gold? These asset classes can provide a real statistical hedge since they approximate latent market-risk factors. “Suppose we ask a representative investor what risk factors drive global capital markets, that is, all equity, bond, FX, and commodity markets,” says Gounas. “Possible answers might include economic growth, monetary policy, and low interest rates. The good news is that there is a purely statistical answer to this question by combining the time series of all global equity, bond, FX, and commodity markets (as well as some macroeconomic variables such as inflation) and applying a “big data” concept called principal component analysis. This technique allows us to extract latent market-risk factors directly from financial time series.”

These purely statistical risk factors explain the movements of global capital markets by construction. The four most important risk factors already explain 67 percent of the movements of all equity, bond, currency, and commodity markets between 1999 and 2020. “The explanatory power increases to 77 percent when we look at the six most important risk factors,” says Gounas. “A handful of risk factors can explain the complex movements of global capital markets. Is that not surprising? These risk factors have the benefit of being perfectly uncorrelated with each other. Investors could construct perfectly diversified portfolios if they were able to directly invest in these statistical risk factors.”

While these perfectly diversified risk factors are not directly investible because they are purely statistical, one can sufficiently approximate them. It turns out that risk factor one mainly correlates with equities. Risk factor two has a high correlation to the USD/EUR rate, and risk factor three correlates strongly with government bonds. Finally, risk factor four exhibits a high correlation with gold. Summing up, by approximating the four most important risk factors with equities, dollar exposure, government bonds and gold, investors can construct efficiently diversified portfolios. This is an easy to implement result since all of these asset classes are investible via cost-efficient ETFs.

“Equities have the purpose to generate return during positive capital market scenarios,” says Gounas. “During less optimal scenarios, dollar exposure and currency-hedged US government bonds serve as a hedge. In extreme events such as hyperinflation, the best bet is gold.” Looking back at 2020, the greenback provided a hedge to equities when the panic in the market was largest (mid-March 2020). Currency-hedged US government bonds outperformed their European counterparts, and gold gained in value. Market scenarios where equities, bonds, the US dollar and gold all fail are unlikely – “and in that case, we should stay away from capital markets”. For most investors, this is not a valid option.


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