Has the well-established presumptively prudent practice of diversification run off the rails to the point where it actually increases, rather than reduces risk? Based on communications I've had lately with Vanguard regarding the Personal Advisor Services plan they tired to sell to my 88-year old mother, close examination of Wealthfront and Bettement robo portfolios, and some debate in which I participated on investment advisor website, I'm beginning to fear that the concept is, indeed, being dangerously misapplied with mindless adherence to dogma trumping client needs.
Kurt Vonnegut, Investment Guru
If you haven't read the short story "Harrison Bergeron" in Kurt Vonnegut's 1950 Welcome to the Monkey House collection, do so (and do it now, and I'm not being paid to recommend it ). To give you a sense of what it's about and why my mind races back to it every time I read something by or about Vanguard, Bogle or anyone else who espouses that philosophy, consider the following passage from the third paragraph of the story:
"Hazel couldn't think about it very hard. Hazel had a perfectly average intelligence, which meant she couldn't think about anything except in short bursts. And George, while his intelligence was way above normal, had a little mental handicap radio in his ear. He was required by law to wear it at all times. It was tuned to a government transmitter. Every twenty seconds or so, the transmitter would send out some sharp noise to keep people like George from taking unfair advantage of their brains."
This, essentially, is the sort of world to which advocates of indexing aspire. While the ruling authorities in Harrison Bergeron's world thought it was unfair of people with above-average intelligence to benefit from their metal capabilities, indexers go a step further and suggest that a money manager who thinks he or she has above average intelligence is probably deluded and that their clients would be better off if the manager was distracted by a metaphorical beep every 20 seconds to prevent them from trying to figure how to do something other than buy index funds.
For many investors and money managers, this makes sense. If you can't predict, don't predict. Just the other day, I argued in the Adviser Perspectives forum against using the standard (among quants and academicians) "expected return" modeling framework because of the way it forces us to pretend we can predict the unpredictable. Every-20-seconds-beeps that distract one from making bogus forecasts is a good thing.
Suppose, however, Vanguard is wrong. Suppose there are some things we can and do know. And what happens when managers bow to Vanguard dogma, don the mental handicap earpieces, and prevent themselves from acting upon things they really do know. Let's continue and see . . .
Indexing as a Gateway to Diversification
Gateway, as in gateway drug (e.g. marijuana to crack cocaine or heroine)? You can decide at the end.
Once we decide to index, our next step is to figure out what index we should track. To me, this is a very active investment decision whether managers want to admit (and take responsibility for) it or not. But let's try to see the world the way they do.
We won't make choices because if we do, we'll probably screw them up. Yet we're confronted with so many asset classes (all of which are investable nowadays as index funds). What to do, what to do?
The Vanguard's Principle's For Investment Success addresses the question. On page 13, it presents the following image:
Figure 6 in the Vanguard Document
On page 14, it states:
"In practice, diversification is a rigorously tested application of common sense: Markets will often behave differently from each other-sometimes marginally, sometimes greatly-at any given time. Owning a portfolio with at least some exposure to many or all key market components ensures the investor of some participation in stronger areas while also mitigating the impact of weaker areas . . . . The details of Figure 6 don't matter so much as its colorful patchwork, which shows how randomly leadership can shift among markets and market segments.
"Performance leadership is quick to change, and a portfolio that diversifies across markets is less vulnerable to the impact of significant swings in performance by any one segment. Investments that are concentrated or specialized, such as REITs, commodities, or emerging markets, also tend to be the most volatile. This is why we believe that most investors are best served by significant allocations to investments that represent broad markets such as U.S. stocks, U.S. bonds, international stocks, and international bonds."
So diversification is what lets Vonnegut-branded Vanguard-type money managers set up indexed portfolios without being hampered by the every-20-secomd-beeps that inhibit them from choosing among indexes. In other words, they buy (diversify among) all the big-name offerings. No choices needed. (We'll wink and give Vanguard a pass for the little cheat we saw, elimination of specialized indexes; the beeper must have been out of order for a few minutes).
Diversification as an Obstacle to Addressing Client Needs
Diversification was, indeed, the basis for the email response answer provided by Vanguard spokeswoman Vanguard spokeswoman Katie Hurt to my inquiries about an allocation in long-term U.S. bonds in my mother's portfolio despite it being clear to the firm that she was "Conservative" and in need-cash-now mode.
"While the forward-looking correlation between stocks and bonds will remain dynamic, Vanguard expects a broad-based exposure to investment-grade bonds to continue to play a valuable role in a portfolio as a diversifier-this applies to investors of any and all time horizons. While our outlook for bonds and stocks given initial conditions including yields, inflation expectations, and the performance of assets relative to their historic norms remains guarded, we believe bonds remain a strong diversification option even if their offsetting returns may vary from historical levels." (Emphasis supplied.)
Guarded? Offsetting? I suppose that's the closest the firm's lawyers will allow anyone to get to what we really (wink, wink) know: huge probability of declines, negative returns, losses, red ink. And this is for "investors of any and all time horizons?"
So in the name of diversification, is Vanguard could care less about taking losses in a the portfolio of a client who is not likely to live long enough to see it recouped and whose projected 2017-20 withdrawals are targeted (by the plan Vanguard submitted) to exhaust the recommended 10% cash reserve at the end of 2017 while long-term bonds continue to fall, as per strong probability (in that post, I demonstrate why sensible assessment of risk and potential return makes it almost impossible to justify long-term fixed income in lieu of intermediate-term fixed income).
Ms. Hirt does not formulate Vanguard advisory services policy but there is no doubt that she expressed it correctly, that Vanguard is completely serious about the across-the-board appropriateness of long-term bonds even now, with interest-rates at comically low levels. The question I submitted referenced a 5/26/16 blog by Joe Davis, Vanguard's Global Chief Economist, in which he stated:
"[G]overnment bonds' correlation with stocks suggests that their diversification power has never been stronger. And under some simple assumptions, this higher diversification value offsets the lower expected returns on government bonds. Period.
* * * *
"Since 1871-yes, almost back to the American Civil War-the correlation between changes in stock prices and changes in bond yields has averaged 0%. Over the past five years, the correlation has averaged -0.6%, the lowest in U.S. history
"In portfolio construction, assets with a strongly negative correlation to other portfolio assets are the Holy Grail.
* * * *
"Stock-bond correlations in the United States have tended to fall in periods of slow growth and deflationary fears, the environment that has prevailed over the past few years. Our outlook suggests that such conditions are likely to persist in the years ahead."
Mr. Davis illustrated using a chart he sourced from Robert Shiller:
Look at the far right side of the Shiller chart. That's what has Davis so excited about long-term bonds.
Here's the problem. Low correlation with stocks doesn't mean long-term bonds will deliver good returns. It only means that, if the low correlation persists into the future (a big "if" since correlation is a backward-looking statistic), it would deliver returns that are very different from those of stocks. So yes, it is definitely possible long-term bonds will remain a great diversifier, if stocks perform well or tolerably and long-term bonds collapse. Is that what a money manager should want for a client, especially an 88-year old and whose projected 2017-20 withdrawals are targeted by Vanguard to exhaust the recommended 10% cash reserve at the end of 2017?
Is negative correlation really the "Holy Grail" of anything outside the classroom? I respectfully suggest that the only "Holy Grail" is a best effort to meet clients' needs and goals.
You Get What You Pay For
Investors don't pay much for Vanguard Personal Advisor Services (0.30%) or for other robo advisors (usually less than 0.30%). But then again, they aren't necessarily getting investment advisors that look out for their interests. They're getting advisors who may not have properly assessed their needs and advisors whose metaphorical wearing of Harrison Bergeron style mental handicap ear plugs may be obstructing them from recognizing when real-world diversification and negative correlation actually work to increase risk, which clients may see not through standard deviation or other conveniences adopted by quants to enable themselves participate in the markets but through a real-people definitions such as that of from Merriam Webster:
- possibility of loss or injury : peril
- someone or something that creates or suggests a hazard
- . . . deleted by me as relating specifically to insurance jargon . . .
- the chance that an investment (as a stock or commodity) will lose value
This is not to say Vanguard or all robo advisors specifically allocate anything to long-term bonds. Actually, Vanguard does it through inertia or reverse engineering by putting all clients into an open-end bond fund, Vanguard Total Bond Market Index Admiral Shares (MUTF:VBTLX) that has whatever long-term allocation Mr. Market just so happens to give it. Other robos do it through ETFs like Vanguard Total Bond Market ETF (NYSEARCA:BND). The key is that they could choose funds focused on short- or intermediate term bonds but refuse to do that since it would require thought and violate the Harrison Bergeron no-thinking rules.
And the issue goes further than long-term bonds. Vanguard and robos dedicate substantial portions of client assets to foreign markets and face similar questions regarding the wisdom of taking un-hedged foreign currency risk even for clients with near-term dollar-denominated cash needs. Vanguard, to its credit, uses a foreign bond fund that is currency hedged (according to Hirt, "currency hedging is prudent in that it reduces the fund's volatility") but doesn't do likewise with foreign equity exposure ("currency exposure is left un-hedged primarily because lower correlations between currency movements and stock prices can create an additional layer of diversification" - in other words, we're back to diversification for diversification's sake).
The bottom line here is that it looks like the Harrison Bergeron (don't think too much) money-management culture has led to diversification taking on a life of its own separate and apart from common sense notions of risk and even specifically articulated client goals.
For the record, mother rejected the Vanguard plan. Se has no foreign exposure and I put her in a short-intermediate fixed-income ladder using Guggenheim investment grade bullet-shares. You can track that Portfolio123 Smart Alpha portfolio for free. She also has Vanguard High Dividend Yield Index Fund (MUTF:VHDYX), which despite a name that sounds junk oriented, is actually high quality, and some annuities which she did not cash out of in order to add funds to Vanguard (annuities carry high fees, but are a bargain in retrospect given that they've been magnificent and then some in actually meeting her specific financial goals.)
Disclosure: I/we have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.
I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it. I have no business relationship with any company whose stock is mentioned in this article.