Choosing the right mix of investments or managers is a critical service many advisors offer their clients. After setting an appropriate asset allocation target for a given risk mandate, an investor employs a strategy using a diverse set of stocks and bonds, often through the use of third-party managers. Below are five common assumptions surrounding what it may mean to be “properly diversified,” especially within an equity allocation.
A well-diversified portfolio requires a different fund/manager for each style box.
Financial advisors often seek diversification within equities by segmenting equity strategies into styles (Large Value, Small Growth) and geographies (U.S., International, Emerging Markets). Based on correlations, however, it is perhaps more important to focus on diversification across sectors.
The correlation table below shows monthly returns going back 10 years and the various correlations of style box indices with each other. Ideally, we would like to find investments that exhibit lower correlation (those that behave differently than each other) as we seek to dampen the overall volatility of the portfolio. Notice how the lowest correlated relationship on the table below (Small Cap Value vs. Large Cap Growth) is 0.80, which is still a strong positive correlation.
Consider the correlation table below of S&P 500 sectors and the amount of cross-correlations that are less than 0.80. These correlations are a much more compelling argument for diversification than starting and stopping the diversification conversation at style boxes.
An advisor may look to allocate capital to the best performing manager of each style box but, if that leads to a portfolio of momentum managers that have all over or under-weighted the same sectors, the realized diversification benefits may be less than desired for a particular client when the market environment changes.
International diversification is only found by investing in companies outside the U.S.
For many years, investment pundits have focused on the opportunities within the universe of thousands of publicly-traded companies domiciled outside of the U.S. It is usually shortly after calendar year-end when capital market return expectations are adjusted. For more than the last couple of years, forecasters have considered how much international equities have underperformed and the opportunities that should arise if these trends mean-revert. These fortune tellers often fail to convey the story of the international revenue exposure already found among U.S. companies as the rise of globalization in this technological age has made the world smaller.
As of 2018, Standard & Poor’s estimates the percentage of S&P 500 sales from foreign countries was 42.9%. Of course this varies by sector and by industry (see estimated geographic revenue exposure by S&P 500 sector below). In the instance of Information Technology, which constitutes about 25% of the index, more revenue is generated outside the United States than within it.
Of course, there are merits to considering opportunities of investing outside the U.S. However, if one is seeking to invest in companies with revenue exposure to the global economy, the U.S. equity universe offers a sizable amount of opportunities.
Standard deviation is the best measure of risk.
Most wealth managers are constructing portfolios with the goal of maximizing return per a given level of risk, which is usually defined as standard deviation.* A critique of this approach is that the typical high-net-worth investor defines risk as the chance their account balance will show a lower value than the last time they checked it.
Measures like standard deviation don’t consider that volatility to the downside (a sharp decrease in value) is much more painful than volatility to the upside (a sharp increase in value) for the average investor. Alternative studies or metrics that emphasize downside risk may be preferable for the typical private wealth client. Volatility metrics should be considered and portfolios constructed for times when risk matters. Capital markets behave differently during different market regimes, and a primary goal of diversification is to find assets that might outperform or serve as a ballast during periods of market turmoil. A portfolio might have a great average standard deviation, but if a single drawdown** is so high that an investor panics and sells at the bottom, the allocation has failed the client. There are also plenty of non-quantitative risks to consider beyond just price volatility. This brings us to our next assumption.
Value strategies are the only way to diversify from growth exposure.
We believe it is safe to assume that the goal of the equity portion of a portfolio is to grow over time. “Growth” as a style or a factor tends to include companies that exhibit high growth of earnings, cashflow, and revenue, both historical and projected. At Eventide, we believe companies that are leveraged to long-term secular growth themes will outperform over time. And while there will be periods where cyclical sectors or growth/momentum stocks will sell off and underperform, value equities have not historically been “up” when growth stocks are “down.” In fact, when markets sharply sell off because of future growth concerns, growth stocks often trade at a premium when growth is viewed as scarce. Historically, bonds and cash have exhibited negative correlation with growth stocks, not value equities, during large selloffs.
Looking at the sector correlation tables above, the diversification benefits of a “value” manager is best explained by weights to sectors with defensive qualities. Rather than looking at “value” as an obscure factor to provide relative safety, it might be best to consider relative exposure to sectors or stocks with defensive qualities, such as stable cash flow or healthy dividend growth. It is common for investors to mistakenly interchange the term “value” with “quality.” The argument that a utilities company with stable earnings will behave differently than an early stage tech firm with no earnings yet, for example, is more compelling than “I need value to offset growth.” Stronger stories lead to stronger convictions, and strong convictions lead to better investment outcomes.
More managers and funds = better diversification.
Similar to why one might invest in more than one stock in an equity portfolio, there can be diversification benefits to increasing the amount of funds or managers in a portfolio. However, at a certain point, these marginal diversification benefits become diminishing. The purpose of diversification is to reduce unsystematic (non-market) risk. Theoretically, if unsystematic risk is virtually eliminated with a large pool of managers, then what is left is market (beta) risk, which leads to market return. If an allocator has chosen mostly active managers in this pursuit, then, at the end of the day, the investor may be paying active fees (on top of the advisor fee), for beta (passive) performance, thereby locking in underperformance over the long term.
This “many-managers” approach is perhaps best observed within endowments and large institutions. It is common for very large clients or institutions to employ more managers and allocate to many sub-asset classes in an effort to achieve diversification that demonstrates their level of sophistication. Unfortunately, the “endowment model” has struggled as U.S. equities have outperformed most other public—and in some cases private—asset classes. While past performance is no indication of future performance, consider the graph from FundFire below as an example. It shows that the gap in 10-year performance between very large endowments (>$1B) versus small endowments (<$25M) has reversed trend as a result of this sub-asset class, many-managers approach that the large endowments have largely relied upon.
A financial advisor has a fiduciary duty to invest their clients’ assets appropriately, considering their objectives and circumstances. As it relates to portfolio construction and implementation, the most important consideration is broad asset allocation—stocks, bonds, cash—not manager or security selection. Broad asset allocation has proven to be the primary driver of risks, and portfolio management is the management of risks, not returns. There is merit and value in considering factors and exposures that go deeper than a simple allocation to stocks, bonds, and cash, but investors should not lose sight of the relative importance of deciding between risk-on (equities) versus risk-control (bonds, cash). These decisions have the greatest impact on the investor’s experience, so we should be giving most of our time and attention to these issues.