As a recent article showed, the classic takes on portfolio diversification don’t work any more. To make a portfolio hold steady through bad markets and still shine in good ones, investors must extend their notion of diversification and, in many cases, go beyond it.
Devised in the 1980s, the notion of diversification distributed a portfolio’s allocation across geographical regions and asset types. Globalization has blown that idea to pieces: world markets and many asset types now pulse in sync.
And as a result, as a T. Rowe Price study points out, during the 2008 financial crisis “not only did correlations increase on the downside, but they also significantly decreased on the upside. This asymmetry is the opposite of what investors want. Indeed, who wants diversification on the upside?”
Back to basics
The article proposes a number of directions in which one can think of diversification.
1. Stay with the “classic” – The T. Rowe Price study confirms that the classic separation between stocks and bonds still presents one of the most desirable diversification footprints: low correlation in down markets, increased correlation in up markets. But beware: this correlation works only between government treasuries and stocks. In a chase to increase returns in a depressed interest rate environment, many bond portfolios today are geared toward high-return, higher-risk corporate bonds. In a market downturn, such a bond portfolio will tank, along with stocks. The name “bond” in itself does not ensure diversification.
2. Play sectors and regions – “Diversification across industrial sectors constitutes an obvious, though neglected, area,” claims Guy Mineault, a public speaker and retired economist of Université Laval, in Québec. Some sectors will hold better than others in market downturns as well as in upturns. For example, when manufacturing drops, consumer goods can pick up some of the slack.
The same holds for geographical regions, which can still exhibit lowered correlations in good and bad times. There are some years when the Canadian stock market performs significantly better than the U.S. or European markets. But watch out for portfolio overlaps, warns Mineault. The Canadian portion of a portfolio is often concentrated in energy and financial stocks. If the same types of stocks are strongly present in the international portion, those two parts of the portfolio will dance to the same down and up beats.
3. Practice asset type purity – People at Picton Mahoney Asset Management have thought hard and long about diversification. Starting from an elaborate sample of 127 asset types, their research boiled that down to 9 “pure” asset classes that exhibit similar behavior patterns in similar economic environments: 5 classes round up stocks and bonds, 4 classes are “diversifiers” such as energy, industrial metals, precious metals and grain.
“We want pure asset classes, not confused ones,” says Michael White, portfolio manager at Picton Mahoney. A pure class is little contaminated by other asset classes and market drivers, while confused classes are exposed to “extraneous” factors. For example, “infrastructure” is not a “pure” class “because its behavior is sensitive to rate, equity and commodity exposures,” White notes.
4. Factor in risk factors – “Investor portfolios can often be over-exposed to single factors – for example value,” states a Picton Mahoney document. This means a portfolio may not be as diversified as it could be and may be susceptible to unintended risks. With this in mind, the firm constructs its portfolios with five key factors: value, momentum, yield/carry, volatility and size.
Some new ideas
These four approaches favour asset categories, the classic building blocks of diversification. But portfolio management today ventures beyond diversification into risk and correlation management. Diversification “comes from the way we manage, not from simply throwing a few more assets into the mix,” says Neil Simons, portfolio manager at Picton Mahoney. Focus on strategy versus simple asset mix, he adds, to deliver results that are uncorrelated during market duress.
1. Ride momentum – In the T. Rowe Price study, momentum stands out as the foremost factor strategy and the most efficient diversifier. Currency momentum shows an almost ideal negative correlation of -0.85 in market selloffs, however its performance in rallies is almost null at -0.1. (1.0 would be a perfect correlation) Cross-asset momentum exhibits the most desirable footprint of all: a very low downside correlation of -0.2, an upside one of .8.
On the other hand, “Cross-asset momentum’s basic pattern is quite simple: you buy long what moves up and sell or short-sell what goes down” explains Richard Guay, professor at ESG UQAM, in Montreal, and an ex-president of the Caisse de dépôt et placement du Québec. Well played out, this strategy can increase returns whatever the direction the market takes.
2. Aim for market neutrality – Most hedge fund strategies stand out as quite disappointing in the T. Rowe Price study, except one: equity market neutrality. A majority of investors think basically in terms of market direction: they want to gain from a rising market and lose as little as possible from a falling one.
Market neutrality steps out of that dilemma. “Our strategy is to stay as close as possible to market neutrality all the time," says Simons. "We try to entertain as little sensitivity to market direction as possible. What return we get is a spread between your long and short positions, and it is a return differentiated from the market.”
3. Manage your downside – This strategy, proposed by Guy Mineault, applies mostly to mutual fund investment, but can also be used in individual stock picking. When choosing a fund or a stock, identify years of market downside like 2002, 2008, 2011 and 2015 and see how the fund or the stock has fared in those periods. Very few fund managers show repeated resistance in market downturns, but some do, and they are the ones to watch. That is, of course, if you adhere to Warren Buffett’s two first rules of investing. Rule 1: don’t lose money. Rule 2: don’t forget rule 1.
4. Manage volatility – This approach, proposed by Richard Guay and the T. Rowe Price study, strives to reduce exposure to the riskier assets in one’s portfolio as volatility in markets increases. A variation on this theme, proposed by Guy Mineault, is to stay close to the historical highs and lows of an asset. If its historical high is 20$ and it now hovers around that price, sell it. If it hovers around its historical low of 4$, buy it.
5. Lead the economic cycle – Different phases in the economic cycle command different asset mixes, something the Picton Mahoney managers practice systematically. For example, when the cycle is in accelerating growth, a portfolio should concentrate on high yield credit and developed market equities. In a recession phase, it should move to interest rates and precious metals.
Of course, moving beyond simple asset diversification requires a higher level of commitment and micro-management from an investor. If he is reluctant to dwell into such detail, an investor would be well advised to look for funds and managers that implement some of the above strategies.
