Diversification Is Not Dead, You've Just Been Doing It Wrong

 |  Includes: DBV, WDTI
by: Efficient Alpha

By Peter Pearce

This is part of the twenty articles written exploring the myths in popular investing as exposed in Michael Dever’s new book, “Jackass Investing.” In the book, Dever uses experience from three decades of hedge fund management to explore how the conventional wisdom in investing and portfolio management preaches little more than gambling.

The phrase “correlations go to one in times of stress” is almost an axiom in financial markets nowadays. As shown in Myth 8, market sectors that typically exhibit low correlation with one another can suddenly exhibit increased correlation during bear markets. A note for beginners, correlation is a statistical measure of how two securities move in relation to each other. Low correlation between your positions creates diversification.

Bear markets are precisely the time when investors need protection, and in late 2008, articles like this New York Times piece began appearing declaring that diversification had failed. In this article, Myth 18: Diversification Failed in the '08 Financial Crisis, we'll show that it wasn't diversification that failed during the crisis, but conventional wisdom.

Conventional wisdom says you can create portfolio diversification by allocating between: fixed income, equity, cash and maybe some real estate. Allocate your equity position between many different sectors is the mantra you’ve heard repeated over and over. But conventional wisdom fails to acknowledge that correlations change in different states of the world. During bull markets, the performance of equity is driven by factors specific to that sector or stock, but during bear markets, all sectors become dominated by fear and correlation increases.

Diversification is effective because when one sector falls, the others rise or fall much less. Your portfolio is not diversified if the correlations of all your investments go to one and you suffer losses across the board.

Here is a graph of the performance of U.S. stock market sectors during the bear market of 07-09; notice how each market falls in lockstep.

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Below is another graph which shows the performance of components of a portfolio built on conventional wisdom. A portfolio that included all the components listed below would be considered highly diversified by conventional wisdom and a model for the average investor.

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Yet just about every component of this portfolio sustained serious losses during this bear market. Only the U.S. and high yield (HY) bonds made any gain over the 2 year period. If you had allocated equally between these components, your portfolio would have taken a loss of 40%. A portfolio where nine of eleven components are highly correlated can hardly be considered diversified. This is why I disagree with the New York Times article.

Diversification didn’t fail because the conventional wisdom portfolio was never really diversified. All of the non-fixed income components were dependant on a single return driver and required markets to rise in price to profit.

The best portfolio managers appreciate that correlation structures change during times of stress, and incorporate strategies in the portfolio to better protect during these times. As mentioned earlier, components of the portfolio must move in different directions to protect the investor. As has been the theme throughout these articles, and the Jackass Investing book, combining trading strategies based on a diverse set of return drivers in one portfolio creates true portfolio diversification.

For example, consider the graph below which shows the performance of a number of trading strategies we’ve previously outlined in this series.

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What immediately jumps out of the graph is how differently all these strategies performed from one another. These 5 strategies derive their returns from very different return drivers which is what causes them to behave so independently. Combining all of the strategies above, including the “conventional wisdom”, into a portfolio would produce true diversification and consistent returns across a variety of market conditions.

To highlight why diversification across traditional asset classes isn’t effective, consider this graph below which shows correlations to a “Conventional Portfolio”. The “Conventional Portfolio” allocations used below are approximately those of a typical Target Date fund designed for someone with 25 years until retirement.

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It’s quite clear that the trading strategies outlined in the book Jackass Investing, and our articles, provide much more diversification value than the traditional asset classes. Limiting yourself to the traditional asset classes is a mistake, and will cause you to take on unnecessary risk.

It might seem daunting to an individual investor to have a portfolio comprised of various trading strategies, but don’t be put off. Many of the strategies can be invested in through a mutual fund or ETF (such as WDTI for trend-following) or are very simple strategies.

For example, we can capitalize on trending market behavior by investing in the WisdomTree Managed Futures Strategy Fund ((NYSEARCA:WDTI)) that tracks the S&P Diversified Trends Indicator. The DTI is designed to capture the profit potential of price trends by using a simple strategy to take long and short positions in 24 commodity and financial futures markets.

To undertake a carry trade strategy, we can invest in the PowerShares DB G10 Currency Harvest ETF (NYSEARCA:DBV), which tracks the performance of the Deutsche Bank G10 Currency Future Harvest Index-Excess Return. The DBV is designed to capture the trend where currencies with low interest rates typically rise in value compared to currencies with high interest rates.

For more information about these two ETFs, I would recommend reading through the articles mentioned above. The articles in this series were written with individual investors in mind, and each article includes some actionable advice for the strategy.

The 5 strategies shown in the graph are just a few that can be included in your portfolio. There are liquidity, momentum, carry trade and many other strategies available. Any investment style that has been identified as profitable which captures a return driver not already in your portfolio would help with diversification.

To conclude, I don’t intend to dissuade investors from holding a core static long position in the components which make up the conventional portfolio (i.e. equity, fixed income and real estate). Static-long components should certainly make up a part of your portfolio, but it’s important to understand that correlations are not stable, and a diversified portfolio should be created with a mix of several strategies based on different return drivers.

Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. This series has been written on a contracted basis with the book's author. The opinions expressed in the article are those of Efficient Alpha and not necessarily those of the book's author. We have been contracted to describe strategies and concepts used within the book but not to promote or recommend any strategies, the author, or the author's services.