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How Homogeneous Diversification in Balanced Investment Funds Affects Portfolio and Systemic Risk

Journal 34: Cass-Capco Institute Paper Series on Risk

Rocco Ciciretti, Raffaele Corvino

The recent financial crisis highlighted the dangers of systemic risk. In this regard no common view appears to exist on the definition, measurement, and real impact of systemic risk on the financial system. This paper aims to analyze the relationship between systemic risk and portfolio diversification, highlighting the differences between heterogeneous and homogeneous diversification. Diversification is generally accepted to be the main tool for reducing idiosyncratic or portfolio-specific financial risk, however, homogeneous diversification also has implications for systemic risk. Using balanced investment funds data, the empirical analysis first investigates how diversification affects the two components of individual portfolio risk, namely systematic, and idiosyncratic risk, and then uses an estimation procedure to examine the change in asset allocation and its impact on global systemic risk. The results suggest that funds’ portfolio diversification reduces at the same time the portfolio-specific risk and increasing the likelihood of a simultaneous collapse of financial institutions – given that a systemic event occurs.

The recent financial crisis highlighted the dangers of systemic risk, and led to academicians, as well as financial executives, to consider its implications on the functioning of the financial market. The debate on the definition of systemic risk as well as on the sources of the last turmoil is still open. For example, Schwarz (2008), while discussing systemic risk, states that “if a problem cannot be defined it cannot be solved,” and Tirole (2002) argues that “two crises are never identical and each one shows own distinctive elements.”

Given that the last crisis may be considered as an example of systemic crisis, our research investigates a potential root of systemic risk, namely the degree of homogeneity among market agents as consequence of their portfolio diversification strategies. The common thread among definitions of systemic risk in the literature is that it has an adverse effect on the stability of the financial system [Brownlees and Engle (2010); De Bandt and Hartmann (2010); Lehar (2004); De Nicolo and Kwast (2002)]. Hence, if the agents are homogeneous the likelihood that a systemic event will affects them all in the same way increases. Thus, portfolio diversification, usually considered as one of the most important tools for mitigating risk and implemented by financial investors to reduce portfolio risk, may increase the likelihood of a systemic crisis.

The aim of this paper is to examine these two sides of the diversification process by analyzing the impact of diversification on different types of financial risk. More precisely, we investigate over the past 10 years how diversification has impacted portfolio and systemic risk. The former may be divided into two components: i) systematic risk, which stems from the sensitivity of portfolio returns to market returns, and is usually measured through the portfolio b factor – the correlation between the port-folio and market returns; and ii) idiosyncratic risk, which depends on the specific portfolio factors and is the portion of portfolio risk not explained by market factors. In the financial literature, systematic risk is considered non-diversifiable while the latter may be reduced through an adequate portfolio diversification strategy which neutralizes the risk-components related to portfolio-specific factors [Goetzmann and Kumar (2008); Fama and MacBeth (1973)]. Consequently, if the portfolio idiosyncratic component is reduced, the level of mutual homogeneity among market agents increases, making them vulnerable to a simultaneous collapse when a negative systemic event occurs. Thus, starting from different conditions and expectations, market agents become homogeneous because of their portfolio diversification strategies, increasing the level of systemic risk in the financial system.

Our investigation proceeds along three consecutive steps. Firstly, portfolio systematic risk, or the beta factor, is estimated and analyzed. Secondly, the relationship between the idiosyncratic portfolio risk and portfolio diversification is investigated. Finally, the impact of portfolio diversification and homogeneity level of the financial system on the likelihood of a simultaneous downturn is assessed.

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