Relying on expected returns and volatility means a lack of diversification

The transition from theory to practice is often a dangerous business. And when it’s done during turmoil in the stock markets, it can even be a problem. But that’s what Antoine Marmuaton of Alken AM has achieved.

Antoine Marmuaton

Thanks to the model he developed, he can tell you whether your investments in convertible bond funds offer a real diversification of the risks taken.

A very useful compass to weather the next upheaval in the markets.


You have been working for several months on an analysis tool that should provide a different perspective on the behavior of convertible bond funds. Can you explain to us exactly what this is about?

A little over a year ago, we decided to take a more systematic look at the convertible bond fund landscape. Indeed, while we knew what we believed differentiated our management process from others, it made sense to try to structure our understanding of what our competitors were doing to create a fruitful discussion with investors. To do this, we created groups of funds using both qualitative analysis and hierarchical clustering, a method commonly used in portfolio management. We found that two axes are most important: the credit quality of investments and the overall level of risk.

This finding alone seems to shake up some established patterns among investors, who tend to be interested in only two parameters: expected returns and the volatility of their chosen investments. How do you explain it?

In my opinion, this is a misjudgment that can potentially be a source of great frustration when someone wants to invest in multiple convertible bond funds. Indeed, as our analysis tool shows, relying on expected returns and volatility means running the risk of not diversifying your investments enough. In other words, the investor risks ending up in funds whose behavior will be similar to a given market event, although it was reasonable to expect diversification a priori. The good news is that our work also shows that some funds actually have very different approaches to what the rest of the market is doing. Therefore, you can diversify your portfolio if you really want to.

How do you think it should be done?

In addition to being aware of this risk of lack of diversification, an investor must fully agree with the goals he sets for his investments. To do this, he can set up an analysis tool like ours based on the actual characteristics of the products and their qualitative research. This makes it possible to divide the market of funds invested in convertible bonds into three groups: the most aggressive products (group 1) from both the credit side and the equity risk side, which are currently actively invested in the US technology segment; those who stick to the index at all costs and the very classic bulge research strategy (group 2) and who represent two-thirds of the market; and finally funds with a quality or defensive profile, which rely primarily on quality loans or reducing risk by limiting their capital.

Is this category stable over time?

Absolutely. And this, moreover, is of interest because it allows, for example, to observe that the performance gap around the mean of the funds in group 2 remains relatively low. From which the conclusion logically follows that investing in several products from this group is not much different from buying only one.

In conclusion, I suggest moving from theory to practice. The US central bank has just raised its interest rates by 75 basis points (the biggest increase since 1994!) and expects inflation to fall to 3% next year. In this context, how can this matrix help an investor?

To understand the utility of our model, we must also analyze what is actually at stake in the economy. Recently, former Treasury Secretary Larry Summers said that the unemployment rate in the United States will be higher than 5% for five years in order to curb inflation in his country. If this scenario plays out, default rates will automatically rise among corporates, and investors will look primarily for convertible bonds with the best credit quality. However, the work done with our matrix allows us to pinpoint which funds are least exposed to this risk of default.

Actually, how do you position yourself in relation to your competitors?

For a fund like our Global Sustainable Convertible, this means that it currently invests primarily in quality (investment grade) bonds. In this uncertain phase of rising interest rates, this is truly the most interesting part of the convertibles market. For their part, high-yield loans are too vulnerable to rising interest rates and the risk of a general deterioration in the economic environment.

Download the document cited in the interview (pdf, English, 6 pages)