Wolf in Sheep

False Diversification

Wolf in Sheep

As proponents of globally diversified portfolios, we understand the principle of diversification when it comes to investing. Harry Markowitz was one of the first academics to identify the benefits of adding additional assets to a portfolio. In theory, assets with different correlations but similar expected returns can reduce the overall volatility of a portfolio without sacrificing expected return. This principle is why Index Fund Advisors has built our portfolios with access to over 53 different countries, over 12,000 individual companies, and over 127,000 real estate properties around the world.[1]

Unfortunately, certain practitioners have promoted a perverted form of Markowitz’s original principle. Mainly, by peddling alternative asset class mutual funds as a way to further increase diversification. Over the last decade, these strategies have increased dramatically in the United States as shown by the chart below.

While many have sold these alternative strategies as a separate asset class, the reality is that they are just different active strategies (for the most part) that have been repackaged. As we would expect, their recent past returns have been pretty disappointing. From June 2006 to December 2015, liquid alternative mutual funds, as a whole, delivered an annualized return of 0.49%. Over the same time period, the widely considered risk-free asset, US Treasury Bills, doubled that. Investors, on average, had to pay 1.38% per year for that dismal performance. Even worse, these funds, in aggregate were highly correlated to the Russell 3000 Index (0.91). So, they performed worse than T-Bills, were highly expensive, and didn’t serve the purpose they were intended to serve, which was increase overall diversification.

In reality, these alternative investments are just a wolf in sheep’s clothing. By overweighting certain stocks and underweighting others, these strategies are just repackaging old school stock picking or market timing or pursuing a more expensive exposure to certain risk premiums in the market.

For example, let’s compare the performance of 2 different strategies. First, a long-only portfolio with exposure to only the Russell 1000 Index. Second, a long/short portfolio that has 150% exposure to the Russell 1000 Value Index and -150% Russell 1000 Growth Index and 100% invested in US T-Bills as collateral. It is important to note that the Russell 1000 Index is equally split by both value and growth stock exposure. Let’s assume that an investor is told that they could further diversify their long-only Russell 1000 strategy by making a small (10%) allocation to the long/short strategy. Her net exposure would therefore be 60% Russell 1000 Value, 30% Russell 1000 Growth, and 10% US T-Bills. The chart below shows the exposure of these portfolios visually.

Have we actually increased diversification? Actually, no we haven’t! In essence, we are just reweighting our exposure to the value premium. We still own the same 1000 stocks, but we have tilted our portfolio towards value stocks. Another weighting scheme would be 60% Russell 1000, 30% Russell 1000 Value, and 10% US T-Bills or 60% Russell 1000 Value, 30% Russell 1000 Growth, and 10% US T Bills. In short, we can create a similar exposure through different weighting schemes, but we haven’t added additional diversification. Again, we still own all of the same stocks. Looking at the historical performance from 1979 to 2015 of these three different weighting schemes, we would expect a similar return. In fact, this is exactly what happened. All three weighting schemes delivered almost the exact same performance as shown in the chart below.

Beyond alternative asset classes such as real estate and private equity, most investors are just trying to diversify through different active investment strategies with the use of liquid alternative investments. It could be stock picking, market timing, or systematically tilting a portfolio towards certain corners of the market. The academic evidence suggests that stock picking and market timing is a losing strategy over the long term. Pursuing different corners of the market is in fact a viable strategy, but you have to be smart about how you implement the strategy. As we have shown, there are multiple ways to implement a value tilt in a portfolio. The long/short strategy is expected to have the worst performance since it is the most expensive. A better alternative would be to invest in a long-only strategy that is well diversified, has low trading costs and turnover, and is properly maintained such as the strategies offered by Dimensional Fund Advisors, which IFA utilizes to implement our 100 Index Portfolios.

[1] Lee, Marlena, Wes Crill, & Philipp Meyer-Brauns. “When Diversification Isn’t a Free Lunch.” Dimensional Fund Advisors, LP. June 2016

Source: Dimensional Fund Advisors LP. with additions by Index Fund Advisors

Past performance is no guarantee of future results. Diversification does not protect against loss in declining markets. There is no guarantee strategies will be successful. Investing involves risk, including loss of principal. Hypothetical Data Disclosure: The returns of the hypothetical portfolios are based on a model/back-tested simulations.
The performance was achieved with the retroactive application of models designed with the benefit of hindsight; it does not represent actual investment performance. Back-tested model performance is hypothetical (it does not reflect trading in actual accounts) and is provided for informational purposes only. Model performance may not reflect the impact that economic and market factors might have had on the advisor’s decision making if the advisor had been actually managing client money. The index is not available for direct investment; therefore its performance does not reflect the expenses associated with the management of an actual portfolio. Past performance is no guarantee of future results.

All expressions of opinion are subject to change. This information is intended for educational purposes, and it is not to be construed as an offer, solicitation, recommendation, or endorsement of any particular security, products or services.