The free lunch that is Diversification is often overused in the asset management industry, as we discussed in Part 1. Here, we discuss why wealth managers are too frequently underutilizing this well known portfolio tool.
Diversification from the wealth manager’s perspective is all about non- and negatively-correlated assets. Let’s start with the basics, stock and bond allocations. Stock allocations are often anti-diversifying from an asset allocation standpoint. It is true that owning a dozen stock funds will reduce the idiosyncratic risk of any underlying company to a negligible level. The non-diversifying aspect arises because a portfolio has to overallocate cash to lower-beta funds in order to increase the portfolio’s beta to the desired level. For example, all of the extra cash used to increase the weighting to Fund A, with a beta of 0.8, to a targeted market risk level (beta of 1), comes at the expense of additional portfolio level diversification that won’t be accomplished.
One solution is to eliminate lower-beta funds that require additional allocation and replace them with higher beta funds that can achieve a targeted risk level with a smaller allocation in the portfolio, leaving additional cash to further diversify.
Bonds are also an asset class in retail portfolios that aren’t well utilized for diversification. What is the market beta of a portfolio with 60% S&P 500 and 40% bond exposures? It is all determined by what bonds are being held, and too frequently equities are being complemented with high yields – which are very highly correlated. Just because the securities are different doesn’t mean they are diversifying from an asset allocation standpoint, e.g. adding high yield corporates to a portfolio of equities. Trading both makes sense in a capital structure arbitrage fund, but owning both is redundant and cash inefficient in constrained retail portfolios.
A solution would be to increase equity exposure further (assuming the equity risk implicit in high yields was being factored in initially), and replace credit exposure with negatively correlated bonds, such as treasuries or agency paper.
The big problem facing retail portfolios is that they are bogged down by capital-intensive, lower-risk funds that drain additional capacity which could be allocated to investments that diversify at an asset allocation level. A litmus test for diversifying asset allocation is the simple question, “did this asset class make or lose money in 2008?” Large caps, small caps, credit and convertibles all lost money, while treasuries, managed futures and trading strategies all made money.
Ultimately, the optimal portfolio is comprised of as many positive alpha, non-correlated investments as possible, which are strategically rebalanced. Moving traditional portfolios in this direction can be achieved through the following process:
Step 1: Replace lower-beta stock funds with higher-beta funds at a lower allocation weighting, and retain excess cash.
Step 2: Sell redundant corporate credit exposure and replace it with enough additional equity exposure to position the portfolio at its target risk level, and retain excess cash.
Step 3: Without reducing market exposures, use the excess cash generated by steps 1 and 2 to increase exposure to truly diversifying investments (in the asset allocation sense of the word, non- or negatively correlated). Again, this can include treasuries, managed futures, and trading strategies.
Step 4: Use a strategic approach to rebalancing this new portfolio, which will capture outsized returns from each of the asset classes represented, and lower the average cost in the portfolio. Rebalancing is the only way a fully invested portfolio can earn more than the sum of its parts.
The higher the quantity of non- and negatively-correlated assets in a portfolio, the higher the available excess return for portfolios that are strategically rebalanced. Reducing the inefficient use of capital that stems from lower-beta stock funds and high yield bonds can free up enough cash to diversify into non-correlated assets in a meaningful way, without giving up targeted market exposures. Staying overweighted in lower-beta stock funds and adding high yield corporates isn't Diversification.
Dave Donnelly is the Founder and CEO of Strategic Alpha, a rebalancing service dedicated to helping financial advisors improve client outcomes. www.Strategic-Alpha.com