Today we’re going to talk about how a lot of what is passed off as diversification does not actually provide much in the way of diversification. To illustrate this we will look at two equity allocations. The first is “diversified.” It owns all kinds of stuff. REITs. Developed market international equities. EM equities. Even ex-US small caps. Wow!
The second portfolio, meanwhile, consists solely of vanilla US large cap equity exposure.
You might think the first allocation would show meaningful differentiation versus the second in terms of compound rate of return, as well as drawdown and volatility characteristics.
And you would be wrong.
Check it out.
From a statistical point of view these portfolios behave virtually identically. (Feel free to noodle around with the data yourself) To the extent there are differences here they are probably just random noise.
How can this be?
It’s because correlations across these assets are high.
As you might expect, correlations are especially high across the three US equity buckets. A full 65% of the portfolio is invested across these three market segments. Just because you have exposure to a bunch of different colored slices in a pie chart does not mean you have exposure to a bunch of differentiated sources of risk and return.
Now, I’m not Jack Bogle telling you to invest only in US large cap stocks. Limiting exposure to country and sector-specific geopolitical risks or asset bubbles (see the early 2000s above) is one good reason to own a global equity portfolio. However, I AM telling you if you want to meaningfully alter the risk and return characteristics of a portfolio, tweaking weights at the margins in this kind of allocation isn’t going to do it.
Perhaps you think manager selection will do it.
Maybe if you allocate to three or four managers and leave it at that; and the managers all perform to expectations (well enough overcome any expense drag); and because of that stellar performance you don’t make significant mistakes timing your hiring and firing decisions… maybe then manager selection will move the needle for you.
But most of us don’t build portfolios concentrated enough for it to matter all that much. And most of us pick a few duds here or there. And we are terrible at timing decisions to hire and fire managers.
Much of the time we spend hemming and hawing about the minutiae of asset allocation and manager selection is therefore wasted. Should emerging market equity be a 5% or 7.5% weight in the portfolio? I don’t know. More importantly, I don’t care. It’s a 250 bps difference in weight. Just do whatever makes you (or your client) feel better.
In fact, if you’re going to add EM at a 5% max weight because some mean-variance optimization shows it marginally improving portfolio efficiency, you officially have my permission to avoid it all together. The same goes for your 2.5% allocations to managed futures and gold.
I think there are four main reasons why this state of affairs persists:
- Many folks, even professionals, don’t understand how the math works. Most people I’ve shown this kind of analysis are surprised how little difference there is in the above performance characteristics.
- Many folks who do understand how the math works see the truth (rightfully) as a potential threat to their job security.
- Advisors and allocators sometimes worry if they don’t futz and fiddle with things at the margins or throw in some bells and whistles, clients may question what they’re paying for. (My friend Rusty Guinn refers to this as adding Chili P to the portfolio)
- At the same time, advisors and allocators can’t futz and fiddle so much they look too different from their peers and the most popular equity indexes, lest impatient clients fire them and abandon their otherwise sound financial plans during a temporary run of weak performance.
All these are valid concerns from business and self-preservation and behavioral finance perspectives. But they don’t change the math.
So what am I driving at here?
If your goal is to harvest an equity risk premium and play the averages as cheaply and tax efficiently as possible… then do that.
If you want to concentrate your bets in hopes of generating massive gains and you’re comfortable with the idiosyncratic risk that entails… then do that.
If you want to employ a barbell or core-satellite structure to balance cheap beta exposure with a selection of (hopefully) substantial alpha generative bets… then do that.
Because if you waver, and you combine this and that and the other philosophy because you’re simultaneously afraid of looking too different and not differentiated enough… then you’re going to end up with something like the world’s most expensive index fund.