Thursday, June 27, 2013

How Investors Can Achieve True Diversification

I just read a great article in Institutional Investor entitled How Investors Can Achieve True Diversification by Andrew Weisman.  Ironically he is from Janus which used to be the poster child for all of your eggs in one basket.  Subscribers can read the article here:

http://www.institutionalinvestor.com/Article/3201055/Search/How-Investors-Can-Achieve-True-DiversificationAnd-Better.html?Keywords=andrew+weisman

He argues the same thing about diversification that we talk about a lot---portfolios that appear to be diversified are really dominated by the same risk factor.  He talks about this in terms of institutional investors but the same ideas apply equally well to individuals.  He makes a couple of great points about portfolios and risk factors:

1. In a standard 60/40 stock/bond portfolio 97% of the variance can be explained by the stock allocation.

2. Many investors mistakenly assume that apparent diversification is actual diversification, that is because:

A. The stock part of a portfolio is obviously dominated by equity risk.
B. The bond part of the portfolio for most investors has moved out the risk spectrum in search of yield, resulting in bonds like high yield corporates that are dominated more by equity risk than duration risk.
C. So called alternative investments are extremely correlated to the S&P 500.  According to the article the HFRI Global Hedge Fund Index has been correlated versus the S&P 500 at a greater than .9 for approximately the past two years.

The cause of this lack of diversification is that institutional investors (and individual investors) have been trained to think of portfolio construction as a collection of assets, which concentrates portfolio risk into a single factor.

The solution that the author points out is simple, yet complex-----portfolio construction should not be by asset class, it should be by risk factor.

This is something we believe wholeheartedly.  In our shop we use different methodologies (counter trend and momentum), different time frames, and different asset classes in our models.

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