What it means
The word granular comes from the idea of grains of sand. A portfolio of fine grains looks smooth and stable, whereas a portfolio of a few large rocks can be lumpy and unpredictable.
In investing and lending, granularity means that every single position is small relative to the whole. The reason it matters is that individual holdings fail or surprise at random.
If one loan out of a hundred equal loans defaults, the lender loses about 1% of the portfolio, which is painful but manageable. If one loan out of four defaults, the lender loses 25%, which could threaten the business.
Banks and credit risk teams pay close attention to granularity. A pool of thousands of small consumer loans or credit card balances is highly granular, so its losses tend to be steady and predictable.
A book of a few dozen large corporate loans is not, and regulators often require extra capital to cover the risk that one big borrower fails. Granularity does not remove risk altogether.
Many small holdings can still all suffer from the same cause, such as a recession, a rise in interest rates or a collapse in house prices. Granularity reduces risk from individual names, which is called idiosyncratic risk, but not the risk that affects the whole market.
A simple way to measure concentration is the Herfindahl index, which adds up the squares of each holding's share of the portfolio. A low value means a granular portfolio, and a high value means a concentrated one.
Analysts often turn this into an effective number of holdings, which tells you how many equal-sized positions would give the same level of concentration.
In practice
Real-world examples.
Example
A consumer lender holds 200,000 small personal loans with an average balance of $4,000. Even if a few hundred borrowers default in a month, the loss is small and predictable, so the lender can set its interest rates with confidence.
Example
A private investor builds a portfolio from a low-cost index fund holding hundreds of companies. No single company is more than a small slice of the total, so a scandal at one firm barely changes her result.
Example
A credit analyst at a regional bank reviews the loan book and finds that three borrowers account for 35% of all lending. She recommends that the bank limit new loans to any single borrower, to make the book more granular over time.
Formula
Calculation
Herfindahl index (HHI) = Sum of (each holding's weight squared)
Effective number of holdings = 1 / HHI
Compare two portfolios of $10,000,000. Portfolio A holds 100 positions of $100,000 each, so each weight is 1% or 0.01, and HHI = 100 x (0.01 x 0.01) = 100 x 0.0001 = 0.01. The effective number of holdings is 1 / 0.01 = 100. Portfolio B holds four positions at 40%, 30%, 20% and 10%, so HHI = 0.16 + 0.09 + 0.04 + 0.01 = 0.30, and the effective number is 1 / 0.30 = 3.33. If the biggest holding failed completely, Portfolio A would lose 1% or $100,000, while Portfolio B would lose 40% or $4,000,000.Case study
Seen in the real world.
Brightfield Credit is an illustrative, fictional lender with a loan book of $500,000,000, of which $150,000,000 was lent to just six property developers. When one of those developers ran into trouble, the lender wrote off $40,000,000, equal to 8% of the whole book.
The chief risk officer realised that the real problem was not the single failure but the shape of the portfolio. A similar loss on a book of 50,000 small loans would have been spread so thinly that it would have barely shown up in monthly profit.
Over the next three years, Brightfield capped any single borrower at 2% of the book and grew its small business and consumer lending. The illustrative result was a steadier income stream, a lower capital charge and a share price that moved far less when single customers got into trouble.
Watch out
Common mistakes.
- Assuming many holdings automatically mean low risk, when all of them may be exposed to the same economic event.
- Judging granularity by the number of positions alone, when weights matter and a portfolio with 50 positions can still be dominated by two large ones.
- Believing a granular portfolio will always earn higher returns, when it mainly gives steadier and more predictable results.
Questions
People also ask.
How granular is granular enough?
There is no fixed rule, but many lenders set limits so that no single borrower is more than a few per cent of the book.
Is a granular portfolio the same as a diversified portfolio?
They are closely related, but diversification also considers whether holdings behave differently from each other, not only how many there are.
Why do regulators care?
Less granular portfolios can be hit hard by a single default, so regulators often require extra capital against large exposures.
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