Not that there aren’t enough acronyms flying around the investment world already, but today I will reference a lesser known one – only to debunk it. TANSTAAFL: “there ain’t no such thing as a free lunch”. The etymology is uncertain, but the principle is intuitive; there aren’t many things in life that come for free without some form of cost, be it direct or indirect, explicit or implicit. However, there is one (and only one) in finance – diversification. Most famously highlighted by Harry Markowitz, Nobel Laureate and pioneer of investment theory, this has underpinned several decades of progress towards building more sophisticated, more resilient approaches to portfolio management. Although well diversified portfolios have arguably disappointed versus expectations this year, we believe they are more relevant than ever in today’s market environment and should continue to be the strategy of choice for long term investors.
First, some caveats. True diversification requires careful research, analysis and consideration. There is no ‘free lunch’ available from just assembling a portfolio that is diversified only by names – a list of different companies or funds that have similar return drivers or characteristics. Also, although defensive assets are often regarded as the best diversifiers for a portfolio, they usually reduce long term return potential. Instead, the ‘free lunch’ argument is strongest when one considers investments with similar return prospects but different drivers and characteristics. This underpins the long-term case for a multi-asset investment approach; combining asset classes and individual securities that are less than perfectly correlated, resulting in portfolio volatility that is lower than the sum of the parts.
However, through the crisis period in February and March, well diversified strategies lagged some that were more narrowly invested. High growth stocks and government bonds mostly held up well, but most other asset classes were hit much harder and cross asset correlations rose to their highest levels in over 20 years. Volatility spiked to over 5x the level of the prior five years in the case of corporate bonds and listed real estate, while even global government bonds collapsed 9% over a 10-day period in March. Some of these moves were consistent with past crises, but the extent of the underperformance of areas such as real estate and infrastructure and the sell-off in corporate bonds were very unusual.
This talks to why well diversified strategies did not provide as much downside protection as may have been expected but should not be viewed as undermining the long-term case for portfolio diversification.
Instead, such an extreme and unexpected scenario should remind us of the fundamental reason for seeking diversification. In what is a similarly possible and extreme theoretical scenario of a cyber virus, the market moves may have been turned on their head with investments in the physical world holding up instead of those in the digital world. The so called ‘FANGS’ (comprising Amazon, Netflix and the like) may be great businesses and ones that we all enjoy the benefits of, but with a universe of thousands of securities to choose from, should an investor in US equities really have nearly a quarter of their money in those few companies like passively managed strategies have?
There’s a natural tendency to concentrate portfolios into yesterday’s winners, either through a passive approach that chases winners by design or as the path of least resistance. Some of the greatest value that professional investment managers can add is through countering the behavioural biases that so often undermine investor returns. Periods of dislocation create high levels of mispricing and present opportunities to multi-asset investors like us and the specialist managers we allocate to. As markets have rebounded since late March many multi-asset strategies have exceeded expectations, particularly those which were invested for the long term and didn’t cut risk at that point of most pain. We believe this outperformance can continue as many parts of markets – including sub-investment grade bonds, real estate securities and value stocks – remain at depressed levels and are paying investors handsomely as providers of capital whilst they wait for a recovery. Many offer yields in the mid to high single digits, compared to near zero for most high growth stocks and government bonds.
Perhaps the coronavirus will threaten portfolios once again, but risks abound and it’s the ones that catch investors by surprise that we should worry about most. There are many known unknowns that could come into greater focus, such as around the US election or a resurgence in trade wars, as well as many unknown unknowns. As was well put by another Nobel Laureate, Neils Bohr: “prediction is very difficult, especially if it's about the future!”. At a time when explicit portfolio insurance - in the form of traditional defensive assets or options strategies - is relatively expensive, genuine diversification should be ever more appealing.