Capital Advisors Group published a research piece yesterday entitled, "Prudent Risk Diversification: Challenges to and Solutions for Short-Duration Investors." Written by Director of Investment Research Lance Pan, its Abstract says, "A common misconception of risk diversification may be that additional credits automatically result in a safer portfolio. Today however, one of the primary challenges in developing a successful diversification strategy for short duration investors is a smaller pool of eligible investments. A mad dash into European financial debt, certain sovereign debt, municipal debt, and bank deposits by money funds and other investors provides evidence that some diversification strategies may actually increase, rather than decrease, risk."
Pan explains, "The benefits of risk diversification are so widely accepted these days that almost every investment policy statement (IPS), including those for short-duration portfolios, requires diversification targets for specific investments. However, investors may not be aware that the pool of eligible investments has shrunk dramatically in recent years. Diversification for diversification's sake, thus, may increase credit risk and reduce portfolio performance. This is especially true for short-duration portfolios in which an increased probability of default may overshadow the incremental yield gained when adding peripheral credits to satisfy diversification targets."
He continues, "In last month's newsletter, we attempted to summarize Eurozone bank credit exposures in U.S. prime money funds. One observation we made from the datasets was that the largest exposures tended to be found within large and systemically important entities. This phenomenon illustrates the trade-off that managers of money funds and separate accounts may often have to make: concentration in large and stronger names versus diversification into smaller, less liquid, and perhaps less credit-worthy names. Our commentary traces the sources of the current dilemma and some possible responses to this issue. Ultimately, we hope to establish that individual credit selection should be at the core of the decision process."
The piece explains, "The aforementioned factors significantly challenge a short-duration portfolio, be it a separately managed account or a prime money market fund, to find ways to diversify risk through investing in other asset categories.... [W]e have noticed several trends in risk diversification that actually introduced new risks to credit portfolios. Less Liquid Foreign Financials: This first trend arose from the ruins of the SIV debacle in late 2007.... Sovereign Guarantors: Fresh credit concerns developed courtesy of the Lehman Brothers bankruptcy in September 2008 when global governments rushed to institute massive liquidity and credit support schemes for their respective banking institutions.... [S]overeign governments replaced the banks they support as the debtors of the bonds, similar to the U.S. FDIC bond guaranteed program.... Municipal Bonds: Yet a third trend of diversification involves taxable investors, including prime money funds, buying tax-exempt securities in the municipal bond market.... Although some of these bonds may offer bona fide diversification benefits, the very fact that tax-exempt bonds offer higher yield than their taxable counterparts ought to sound alarms for potential investors."
Pan adds a "Caution on Bank Deposits," saying, "Another popular, although somewhat less obvious, strategy of diversification is to fallback to simple bank deposits. One of the beneficiaries of the flight from prime money funds after the Reserve Primary fund debacle in 2008 has clearly been the banking sector which benefits from both the liquidity support of the Federal Reserve discount window and the deposit insurance of the FDIC. In the context of this commentary, we would like to comment on two potential drawbacks of good old bank deposits."
He explains, "Money Market Deposit Accounts (MMDAs): As part of the Treasury Department's emergency liquidity measures, the FDIC's Transaction Account Guarantee (TAG) program expired on December 31, 2009, but banks with weak funding access can still continue to tap into the program through December 31, 2010, albeit at higher opt-in fees. Commercial banks sought to retain deposits after the TAG expired by offering depositors higher rates on MMDA balances, which double as sweep accounts. But without the benefit of the TAG, large corporate accounts essentially take on the credit risk of the banks at which they keep their accounts."
Finally, on Aggregated Insured Deposits Programs, Pan adds, "In recent years, deposit aggregators also wooed short-duration investors with aggregated insured deposits from banks in their networks that each offer up to the $250,000 FDIC insurance limit. While these programs have merit in that they facilitate greater access to deposit insurance for smaller community banks to the savers community, large corporate accounts should take note of the programs' inherent limitations. Along with the non-marketable nature of the investments and steep early withdrawal penalties of some of these programs, these deposits are generally operated by a centralized entity that negotiates rates, facilitates transfers, administers recordkeeping and processes subscriptions and redemptions."
