It is common investing boiler plate that portfolios should be diversified, but the Old Institution has a strange way of defining it, reports Landon Whaley.
John Maynard Keynes once said, “To suppose that safety first consists in having a small gamble in a large number of different [companies] where I have no information to reach a good judgment, as compared with a substantial stake in a company where one’s information is adequate, strikes me as a travesty of investment policy.”
Among other concepts that are considered to be irrefutable law in modern finance, so called “diversification” is ingrained as a critical risk management tool. As such, its validity is rarely questioned until now.
The jumping-off point for our investigation is an exchange trade funds (ETF) allocation portfolio from Merrill Lynch. I’m not picking on The Bull here; this approach to managing clients’ money is typical and widespread across the Old Institution. Well, kind of.
At first glance, you’re probably thinking, “This is a well-diversified portfolio, not just across stocks and bonds, but among various U.S. equity sectors as well. Internationally, assets are allocated across both developed and emerging market equities, and the fixed income side of the portfolio has domestic and international exposure as well.”
But as my boy, Ludwig Mies Van Der Rohe said, “The devil is in the details.”
Despite this ML portfolio having 30 holdings (31 if you include the meager allocation to cash), this portfolio is far from offering the downside protection that proponents of diversification often tout.
In fact, of the 20 equity ETFs, 17 of them correlate the S&P 500 at a strength of 0.7 or higher. I apologize in advance for geeking out on you but stay with me. A knowledge of correlation is critical to understanding the inherent flaw of diversification. That is, if you believe a stock dominated portfolio qualifies are diversified.
A correlation of 0.7 (or higher) indicates a strong, positive relationship with the S&P 500. In lay terms, it means these 17 ETFs march nearly lockstep with the S&P 500. And if you think that the other three equity ETFs will save you, think again; their correlations to the S&P are 0.68, 0.66, and 0.64, respectively. (For the record, those correlations, mean that those are NOT diversified investments).
The bond side of the OI-typical portfolio tells a similar story. Of the 10 fixed income ETFs, six have a strong, positive correlation to the U.S.-based Barclays Aggregate Bond Index. And the four ETFs that don’t move lockstep with that index have strong relationships with the movement of the S&P 500 (EM bonds, U.S. preferred stocks and U.S. high-yield bonds)!
Over the last five years, the diversified 30-ETF ML portfolio has gained 8.4% a year with an annual volatility of 12.6% and a fund expense ratio of 22 basis points. In contrast, a concentrated portfolio holding just the SPDR S&P 500 ETF Trust (SPY) and the Barclays Aggregate Bond Index (AGG), weighted exactly as the ML portfolio, would have gained 10.9% a year with just 8.0% volatility and annual fund expenses of 8 basis points. The less diversified portfolio gained 29% more return each year over its diversified counterpart, experienced -36% less volatility, and accomplished all of this with -63% less cost.
Put that in your diversification pipe and smoke it!
I understand that a portfolio chock-full of positions makes you feel good and like you're an effective risk manager. But if you want to feel good, rub your cat; if you're going to be an effective risk manager, you must diversify catalysts, not positions. (As Michael Dever put it in “Jackass Investing: Don’t Do it, Profit from It,” you must have “a diversity of return drivers.”)
You could have 1000 positions in your account, but if they are all driven by the same catalyst, you’ve made the same bet one thousand times.
The most significant risk to your assets is blindly accepting outdated, and dogmatic Old Institution approaches to portfolio management.
The bottom line is that one of the keys to being a consistently successful investor is to concentrate your portfolio based on a keen understanding of the real catalysts (Fundamental Gravity) driving the risk and return in global markets and not based on the flawed concept of “diversification.”
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