from Follow the Money

The lunch may be free, but how much is it worth?

July 9, 2009

Blog Post

This is Mark Dow. Brad is still away.

Diversification is the only free lunch in investing. But the way many investment managers sing its praises, one can’t help but wonder if its value is overstated (much the way all portfolio managers are programed to say in interviews that "it’s a stock picker’s market", no matter what the underlying market conditions). Here’s a graph below that speaks a thousand words.

Brazilian Real vs Turkish Lira, over the past year

This is a chart of the Brazialian Real (BRL, in white) vs. the Turkish Lira (TRY, red), over the last year. They have been nomalized to facilitate comparison. Brazil is well known as a commodity exporter, and Turkey as a commodity importer (oil is a huge component of Turkey’s import bill). Keep in mind that over this same period, the front contract on West Texas crude oil fell from USD 136 per barrel to today’s price of 60, and other commodities--both soft and hard--fell by similar amounts.

You will note the one period of divergence in the performance of these two fundamentally distinct countries came in December of last year. This is due to the unwinding of TARKO (Target Knock-Out) contracts that were sold to Brazilian companies ostensibly as pre-hedging vehicles for future dollar export proceeds. However, once they started "working", these contracts proliferated and quickly became vehicles for specualtion, often by companies that lacked the necessary sophistication in complex derivatives. And had it not been for the coordination of the hedging of these contracts by the Brazilian Central Bank, the December divergence would have been greater. Once this demand for dollars cleared, however, BRL returned to correlate very closely to TRY.

This notwithstanding, the overall similarity of performance over the period would, I think, come as a surprise to most people--given the fundamental backdrop. I know it took the veteran traders I work with by surprise. And while it is true that all correlations "go to one" when markets are under stress, one would still expect to have seen a greater degree of differentiation over the period shown.

A lot of it has to do with fund flows. Funds flows tend to be trendy, with investors getting into and out of strategies--such as emerging market currencies--roughly at the same time. This makes it tough for investors who do their homework and are counting on markets to be rational and efficient. It also makes risk management at least as important as the investment theses themselves.

Once the fund flows come in, the stories that justify the investment follow. Turkey was a great example. Investors at first expressed reluctance to buy TRY with oil going up through USD 100 per bbl. But the story soon followed that made it okay. Strategists and traders started whispering "with oil at these levels there will be large investment outflows from oil producing states, many of which are Muslim. Muslims will feel more comfortable investing their windfalls in other Muslim states, from which Turkey will be a main beneficiary. This will be good for the country and lead to appreciation of TRY". And thus it was so. An investment thesis was born. Later, after markets crashed and oil had fallen to $40 per bbl., TRY started appreciating again. The story then reverted to the old one we all know and love: lower oil is good for Turkey and for TRY. The Muslim investment thesis had disappeared. In short, when prices go up, a good story will follow.

The bottom line on diversification: some is good, but there is an optimal degree. Too much diversification and you may lull yourself into a false degree of security. If you know your corrleations under both normal and stressful states of the world you can keep things simple and still make the same portfolio bets.

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