This piece is for portfolio managers and financial advisors that are attempting to add diversification to their portfolio or examine current diversification positions. We believe that diversification is thought of as non-correlation with many firms. We also believe that additional investments into various segments of the equity market is really more of a relative value bet although the intent many times is diversification.
Within the stock market, there are many sectors, capitalizations, regions and country exposures. If one holds a mostly large cap domestic portfolio and adds exposure to a basket of Latin American Stocks, additional risks and potential rewards have been introduced into the portfolio.
However, another long only stock position is not true diversification but rather a relative value bet. The hope might be that if the US market goes down, then perhaps the Latin American Fund may offset the loss as it may appreciate. It will perform relatively better or poorer depending in part on its valuations and growth prospects.
We believe the firm may have added more risk to the portfolio in the name of diversification. If it is a long only equity fund or ETF, the market risk (beta) remains.
The placement can turn out to perform very well, and that is the hope, but true diversification is also supposed to dampen portfolio volatility.
If we look at the market action on 5/15/12, we can see that a placement to Latin America increased portfolio volatility and performed relatively worse.
An equal dollar placement to six Latin American ETFs would have a produced an equal- weighted daily negative performance of 2.28% on 5/15/12. The S&P500 was down .57% on the same day. The basket was calculated using the following ETFs: I-Shares MSCI Mexico (EWW), I-Shares S&P Latin America (ILF), I-Shares MSCI Brazil (EWZ), Global X FTSE Columbia (GXG), I-Shares MSCI Chile (ECH), Global X FTSE 20 Argentina (ARGT).
We encourage advisory firms to test their portfolio's diversification merits and to examine the absolute legitimacy of any equity placement.
The time period was extremely short and the basket of ETFs is only one of many that could be created to set against the S&P500.
Our aim is to encourage advisory firms to test their portfolio's diversification merits and to examine the absolute legitimacy of any equity placement. The following material is meant to help in that process.
Stocks and Commodities
Commodities are touted as an asset class that has properties able to diversify a portfolio over time. While their is academic research exists to support this over exceptionally long periods of time, the real time reality can be very painful for investors expecting diversification and instead experiencing large losses and heightened volatility.
We will examine two reasonably short time periods to gauge the benefits of commodity exposure in a portfolio.
- One year returns through April 2012
- Broad Based Commodity Basket -17.01%
- PIMCO Commodity Real Return Strategy Fund Institutional Class PCRIX -14.93%
- S&P 500 +4.76
That asset class provided a unique return stream that moved in the opposite of the S&P500, unfortunately, in a magnitude that is more than simply a negatively correlated asset class. It clearly is moved by different factors, although substituting one risk for another is not good diversification.
May 17th-October 3rd 2011
This is the period in 2011 that saw huge drops for the equity markets in general and a good time to hold a diversified portfolio of various asset classes. That was the thought at least, at the time.
- PCRIX- Negative 19.33%
- S&P500- Negative 17.45%
At the time investors needed the diversification the most, exposure to broad- based commodity indexes provided major losses and no diversification benefits.
We do not believe that a broad based commodity index is appropriate simply as a portfolio diversification tool. The factors that drive this segment of the capital markets are powerful and disparate. They range from supply/demand equations in areas such as energy, agriculture, base metals and precious metals. In addition, the currency market dynamics play a role in this asset class performance.
Stocks and High Yield Debt
High Yield Debt is touted as a way to earn equity- like returns with less volatility. There is some evidence of that; however its modest diversification properties should not be confused with non-correlation.
May 17th-Oct 3rd 2011
- HYG-iShares iBoxx $ High Yield Corporate Bond Fund- Negative 12%
- S&P500- Negative 17.45%
- S&P 500 +4.76%
- HYG +5.7%
This asset class can exhibit similar volatility and does reduce interest rate risk and pure equity risk but does not hedge a portfolio in times of crisis. It should not be viewed as a pure hedge but rather a relatively less volatile way to gain exposure to reasonably high expected returns.
Stocks and Stocks
A natural instinct for many in the quest to diversify a portfolio involves a placement in additional segments of the equity market. A domestic large cap portfolio is thought to need additional areas of the global market and we believe there is merit to that as long as expectations are realistic going into the trade and diversification (non-correlation) is not a goal.
SPY- SPDR S&P 500
1YR Performance through 4/12 +4.6%
DEM-Wisdom Tree Emerging Markets
IEV-ISHARES S&P EURO 350 IDX
DEM- Wisdom Tree Emerging Markets Equity Income Fund with a focus on Emerging Markets
1YR Performance through 4/12 -8.4%
IEV-ISHARES S&P EURO 350 IDX
1YR Performance through 4/12 -17.10%
These investments provided exposure to three different slices of the global stock market. If the starting point was the SPY ETF, then diversification accomplished the opposite of it's intent and that is to dampen volatility. The investments gave exposure to different companies and their specific risks although the main stock market risk remained and in these cases, the specific risk unique to those sectors provided diversification in the form of losses. The relative performance hurt overall portfolio safety.
We believe in placements in segments of the same market that appear to offer a compelling case for appreciation based on fundamental analysis and not simply for the supposed diversification benefits.
Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.