portfolio diversification -- where it goes wrong

8/9/2019 Portfolio Diversification -- Where It Goes Wrong

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Financial Planning Disclosures July/August 19

Diversication is one o the undamental ideasin investing. However, the idea o diversication aswe know it in the nancial services industry is onlya little over hal a decade old.

The concept o asset allocation, in which onebuilds a portolio o dierent investments in orderto maximize return and minimize risk, was originallyproposed by Harry Markowitz in 1952 in his classic

paper Portolio Selection.Since that initial paper, asset allocation, whichis ormally known as Modern Portolio Theory(MPT), has become the very backbone o portolioconstruction in the nancial services industry. Thebelie is that by combining assets that are not highlycorrelated to one another (meaning that they actdierently than one another in response to marketorces), one can help control risk.

However, ollowing years like 2008, publicoutcry arises, pronouncing that asset allocation andbuy-and-hold portolio strategies are dead.

Its not hard to concede these arguments i you

look at how most portolios are constructed. Look-ing at the major asset classes included in the typicalportolio, we see that nearly every one o the assetclasses posted negative returns in 2008 (see Table1). A similar phenomenon happened in 2001 and2002, in which most asset classes posted negativereturns.

Given the negative returns in most o the majorasset classes, client portolios as a whole suered

similarly painul losses. As mentioned, the cry hasgrown louder with 2008 serving as proo that assetallocation does not work.

I would argue, however, that it was not that assetallocation did not work, its that the way most port-olios are constructed violate the very basic premiseso modern portolio theory.

In particular, most portolios are constructed o

highly correlated asset classes. Remember, one othe core tenets o modern portolio theory is thatthe portolio comprises assets that are not highlycorrelated to one another. I you look at Table 2,you will see that with respect to correlations, theassets that make up most portolios provide little inthe way o real diversication.

As you will note, every one o the asset classesrepresented in Table 2 are positively correlated tothe S&P 500. All domestic equity asset classes aremore than 80 percent correlated to the S&P 500.International equities (as represented by the MSCIEAFE) are more than 60 percent correlated and

bonds are still positively correlated at 24 percent.This means that all the elements o the portolio

are highly dependent on the S&P 500 experiencingpositive returns to also perorm well.

Without becoming too academic, there are threebasic aws in the way that traditional portolios areconstructed that result in portolios behaving as theydid in 2008.

The rst aw is the process o selecting and ex-cluding various asset classes. The second elementis the articial constraints that are then placed onthe included asset classes. The third element con-

cerns the constraint to long-only investing in mostportolios.

Asset class selectionIn Modern Portolio Theory, portolios should

be constructed o a variety o non-correlating assetclasses. However, when looking at the distributiono investments across asset classes in most retail port-olios, the vast majority o assets are concentratedin large cap, mid cap, small cap, international andaggregate bonds (ICI Factbook, 2007).

According to the Investment Company Institute,

at the close o 2007, approximately 40 percent oU.S. mutual und assets were in domestic stockunds. Twenty-six percent o assets were in moneymarket unds, while international equities and bondunds each represented 14 percent o U.S. mutualund assets.

Many in the industry would call those distribu-tions a well-diversied portolio. However, giventheir high correlations to one another, the resultingportolios constructed using these basic asset alloca-tions are then by deault directionally dependenton the S&P or its returns. Essentially, these w


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20 Practice Management Disclosures July/August

portolios are not as diversied as they mayappear.

The underlying problem with this gen-eralized approach to asset allocation is theexclusion o numerous other viable assetclasses (commodities, currencies, managedutures, structured notes, long/short equi-ties, ination-linked assets, etc.), which can

increase the diversication o the portolio.Many o these non-traditional asset classesoer much lower correlations to both the S&P500 and the other traditional asset classes.

Eliminating available asset classes orcesthe optimization process to create an opti-mal solution o only those things put into

the system. It is not constructing an efcientrontier based on all available investmentchoices. It is, rather, optimizing a portolioo preerences.

Artifcial constraintsThe second issue that distorts the results

o optimizing portolios is the practice o ap-plying articial constraints to the asset classesthat have been included in the optimizer. Iyou think through how portolios are beingconstructed, you can begin to see the truelimitations that are being placed on the abilityto optimize the portolio.

First, only a ew asset classes are usedor consideration in the optimizer. Then theoptimizer is told to put limits on how muchcan be invested in any one o those select ewasset classes. Again, this is more in line withcreating portolios o preerence rather thanprocess.

As stated above, most asset allocation

portolios or U.S. investors will be largely biased to the domestic asset classes (whichalso biases the portolio to the U.S. dollar

but thats another discussion), with in-ternational investing relegated to a smaller,satellite allocation. However, researchershave demonstrated that when an uncon-strained optimization is perormed, even themost conservative o portolios will allocateportions o the portolio to the most risky assetclasses (small cap and international equities).They also note that in an unconstrained opti-mization, large cap U.S. stocks are relegated

to a supporting role.This is oten the exact opposite o how

client assets are deployed. The articial con-straints that are applied in the optimizationprocess will essentially dictate the outcomesin line with the constraints, not along a trueeicient rontier. This process essentiallyconstructs portolios along the lines o theinvestors or advisors preerences, not inaccordance with a true mean-variance opti-mization.

As an example, an unconstrained portolio

built to mimic the standard deviation (risk)o the S&P 500 would be constructed osmall cap equities and bonds. Using historicalreturns and standard deviations, neither theS&P 500 nor the MSCI World Index lies onthe efcient rontier so they are completelyexcluded rom the unconstrained optimizedportolio (see Table 3).

Most investors would simply be uncom-ortable with a portolio made up o only

bonds and small caps. Common sense dic-tates that they urther diversiy the portolio.However, most o the time investors will not

include additional asset classes to solve or theefcient rontier; they will simply apply con-straints to the existing asset classes, restrictingallocations to those perceived as riskier.

Following this logic, i the efcient ron-tier is constrained with a limit o 10 percentto small caps, the resulting portolio is thenorced to include large cap and internationalstocks asset classes that do not reside onour original efcient rontier.

Further, this process o orcing large capand international stocks into the portolio

20 Financial Planning Disclosures July/August

Table 1: A typical portolio

Table 2: Wheres the diversifcation?

Table 3: Unconstrained optimized portolio

2000 2001 2002 2003 2004 2005 2006 2007 2008

S&P 500 -9.1 -11.89 -22.1 28.68 10.88 4.91 15.79 5.49 -37

Russell 2000 -3.02 2.49 -20.48 47.25 18.33 4.55 18.37 -1.57 -33.79

Russell Mid Cap 8.25 -5.62 -16.18 40.06 20.22 12.65 15.26 5.6 -41.46MSCI EAFE -14.17 -21.44 -15.94 38.59 20.25 13.54 26.34 11.17 -43.38

BarCap US Agg Bond 11.63 8.44 10.26 4.1 4.34 2.43 4.33 6.97 5.24

Russell 2000 Growth -22.43 -9.23 -30.26 48.54 14.31 4.15 13.35 7.05 -38.54

Russell 2000 Value 22.83 14.03 -11.43 46.03 22.25 4.71 23.48 -9.78 -28.92

Russell 1000 Value TR 7.01 -5.59 -15.52 30.03 16.49 7.05 22.25 -0.17 -36.85

Russell 1000 Growth -22.42 -20.42 -27.89 29.75 6.3 5.26 9.07 11.81 -38.44

ML US HY Master II -5.12 4.48 -1.89 28.15 10.87 2.74 11.72 2.24 -26.39

1/1979-7/2009 S&P 500 Russell

1000

Growth

Russell

1000

Value

Russell

Mid Cap

Russell

2000

Growth

Russell

2000

Value

MSCI

EAFE

US Agg

Bond

Wilshire

US REIT

S&P 500 1

Russell 1000 Growth 0.96 1.00

Russell 1000 Value 0.95 0.83 1.00

Russell Mid Cap 0.94 0.91 0.91 1.00

Russell 2000 Growth 0.81 0.86 0.72 0.91 1.00

Russell 2000 Value 0.80 0.74 0.84 0.91 0.87 1.00

MSCI EAFE 0.63 0.60 0.61 0.62 0.56 0.56 1.00

BarCap US Agg Bond 0.24 0.21 0.26 0.24 0.11 0.19 0.18 1.00

Wilshire US REIT 0.55 0.48 0.63 0.65 0.56 0.75 0.44 0.19 1.00


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portfolio diversification -- where it goes wrong

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