Miller

Is Diversification Still Your Buddy?

Miller

The title above refers to a famous quote from Nobel laureate Merton Miller, who was a teacher to the Father of Modern Finance, Eugene Fama. It also refers to the fact that for the first three quarters of 2013, most of the diversifiers we use with respect to the IFA US Large Company Index (Roughly equivalent to the S&P 500 Index) had a lower return than it had. Of course, if any of them reliably always had a higher return, then we would dispense with the US Large Company Index and just use the diversifier.

Digging into the numbers, we see that the IFA US Large Company Index had a year-to-date 9/30/2014 return of 8.25%. Here is how our various diversifiers stacked up for the same period:

  • Small companies (represented by a blend of IFA US Small Cap Index and IFA US Small Cap Value Index) lost 2.43%.
  • International developed equities (represented by a blend of three IFA international indexes) lost 1.64%.
  • Emerging market equities (represented by a blend of three IFA emerging markets indexes) gained 4.46%.
  • Global real estate (represented by the IFA Real Estate Index) gained 11.54%.

Thus, only one of the four diversifiers (real estate) ended up with a higher return than US Large Company. The goal of diversification is to increase the risk-adjusted return of the portfolio; this is best achieved by adding asset classes that have a low correlation with the asset classes that you wish to diversify. Ideally, we would love to find asset classes with similar expected returns but negative correlations to US equities, but if such a class existed, it would immediately be bid up in price until its expected return becomes comparable to Treasury Bills. The primary argument for buying international developed equities is their diversification benefit with respect to US equities. It is difficult to argue that they have a higher expected return. For emerging markets equities, it is possible (but not statistically established) that they have a higher expected return as compensation for bearing political risk. Small caps (especially value) have both a diversification benefit and a higher expected return than large caps. The table below shows the correlations with the IFA US Large Company for as far back as the data goes for each asset class. Recall that correlation ranges from -1 to 1, with 0 indicating that the two indexes move completely independently.

 

It is important to note that the IFA Index Portfolios are constructed to capture the various dimensions of risk and return around the world. The three equity and two fixed income risk factors identified by Eugene Fama and Ken French are shown in the chart below. All of them have had many years when they delivered negative returns. Even the most reliable of them, the market premium, was still negative in almost one of every three years.

 

 

 

As we discussed in this article, all three equity risk premiums were found to be statistically significant based on the t-test. This means we can state with a high level of certainty (95 to 99%) that they are positive, but as seen in the chart above and in the alpha charts displayed in this article, they will have periods of negativity. As indicated above, the small premium has hit a rough patch in 2014, with small stocks lagging large stocks by about 10.7% as of September 30th. This is the primary explanation for why IFA Index Portfolio 100 returned 1.10% vs. 8.25% for the IFA US Large Company Index.

To answer the question posed in the title of this article, diversification is still your buddy for the long-term, but even the best of friends can disappoint you over the short-term. If you consider the long-term to be ten years, then, as can be seen in the interactive chart below, IFA Index Portfolio 100 beat the S&P 500 Index in over 80% of the rolling ten-year periods over the last fifty years. If you extend the period from ten years to twenty years, then the percentage improves from 80% to 87%. We think those are pretty good odds.