Diversification Sucks

With US Stocks pushing up to new all time highs once again this week, we’re seeing more talk of going with simple over complex, just doing the basic 60/40 portfolio, and so forth. We’re seeing more of the feeling – “Diversification Sucks!  I would be waaaaaaaay better if was just 100% long US Stocks… or even better, 150% or 250% long.”

We had some clever things to say on this topic, but found the following post out there by James Osborne of Bason Asset Management (from a few months ago) which said it much better:

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Alternative Links: “We Basically Controlled the Oil World”

Crude Oil:

“We basically controlled the oil world,” said  Al Kaplan, former president of Phibro’s energy unit. Mr Kaplan. “It was quite amazing. We had very good people. There was no price dissemination, so we used to tell people what the price was.”

Rise and Fall of a Commodities Powerhouse – (FT)

3 reasons for oil’s crazy bounce – (MarketWatch)

7 Technical Indicators to tell when the Crude Sell Off is Done – (Attain Alternatives Blog)

Managed Futures:

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Pursuing Portfolio Perfection

It’s 5 years into the one of the biggest stock market bull runs of all time, and all looks fine for the aging bull even after this brief downturn in October.  For many, this has been a great run and they’ve been doing quite well during it. For many others, it’s been rather annoying, as their “smart” choice of diversification has under performed recently.

But here’s the deal – it’s not about beating the S&P 500. You’re on the quest to find a portfolio that best matches your needs before retirement. For some, that’s so far in the future, you’re not worrying about volatility. For some, it’s within reach, and you want to protect what you have before something bad happens. For some, you’re looking for something in between the two. So what’s your “Perfect Portfolio?” It’s not an easy question to answer, and many pros have tried (check out Meb Faber’s impressive list of asset allocation strategies and stats here). The basic portfolios to consider in our mind are the following:

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Would’a Could’a Should’a

Woulda Coulda Shoulda
(Disclaimer: Past performance is not necessarily indicative of future results)

Invest like a Billionaire?

When someone first starts investing, there is the sort of high that comes with it; a high that convinces you that you just might be the next Warren Buffet. Sure. You watched a couple investing tips videos on Youtube, and you think you found some ETFs (with extremely low or no fees) that no one else knows about.

The thing is, that feeling never really goes away. The overly active investors are confident that with a little hard work they too will eventually become Warren Buffet. We all know the likelihood of that, so instead the people at Direxion decided to take that idea and turn it into an ETF. What are we talking about? The newly launched ETF Direxion iBillionaire (IBLN). Now you can feel like you’re trading with the greats, without actually doing it. Here is the description:

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Even Bad Diversification Works

Last week, Business Insider unveiled the “Most Important Charts in the World.” If ever there was an outfit with a flair for the dramatic headline, that would be them…but there was one chart that caught our attention entitled, “Diversification Works.” It was from none other than Josh Brown at Ritholtz Wealth Management.

Diversification Works

(Disclaimer: Past performance is not necessarily indicative of future results)
Chart Courtesy: The Reformed Broker

Now if you asked a roomful of random investors what diversification in their portfolio meant to them, chances are all of them would have a slightly different answer. In this particular instance, Brown defines diversification as a portfolio including a 30% allocation to the S&P 500, 30% to foreign stocks, and 40% to bonds. We’ll give you the bonds, but pairing foreign stocks with US stocks doesn’t strike us as all that diversified. Foreign stocks (MSCI ex US) have a correlation of 0.89 with US stocks over the past 10 years. 

And being managed futures folks, we couldn’t help but look at their chart and wonder… what if you had managed futures in the foreign stocks slot instead? Would diversification have “worked” then?

Here’s our chart swapping the 30% foreign stocks allocation with 30% managed futures, per the Newedge CTA Index.

Diversified with Managed Futures

(Disclaimer: Past performance is not necessarily indicative of future results)
(Diversified = 40% Barclays Bond Aggregate Index, 30%  Newedge CTA Index, and 30% SPY)

While Brown was bragging of the diversified portfolio regaining its peak 14 months before a stock-only portfolio, the portfolio containing managed futures regained its peak 35 months prior, or more than twice as fast!  How? Because 30% of the portfolio was positive during the 2008 crisis as managed futures became negatively correlated to stocks during the crisis.  Now that’s some diversification.

Some may concentrate on the far right hand side of both of these charts, where the stock-only portfolio has, after 7 years, eclipsed the total return of the diversified portfolio (whether diversified in other stocks or managed futures), and discount diversification as unimportant or even costly. You would have made more money not being diversified, but that’s not the point for those who want some protection.

The point, as Josh Brown points out, is to have shorter drawdowns. The point is to be able to regain a peak sooner. The point is to be able to not panic at the bottom.  And, of course, the point (for us) is that diversification can “work” even better when you aren’t diversifying with another form of stock market investment (foreign stocks), and instead gaining true diversification with different return drivers.

P.S. – Past Performance is Not Necessarily Indicative of Future Results. The chart should probably be titled – Diversification Worked (past tense), not works (present tense). We noticed a comment summing that up rather nicely, and ask the simple question: Will Simple Beat Complex in the Next 5 Years?

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Do Investors really have to choose between Rotten Eggs?

It seems like nary a day goes by without a new article popping up hating on diversification. Not because there’s anything really wrong with diversification, but because financial journalism seems to think there’s something wrong with diversification, especially with the S&P at all time highs just a couple weeks ago. Take the recent Market Watch article entitled, “Why Diversification isn’t working.”

Much like the majority of articles out there, the headline is a little deceiving. Author Howard Gold isn’t claiming that the idea of the theory of diversification is flawed, but the application of diversifying your portfolio to include other asset classes in this current climate is flawed, as in his words, “investors have to choose between many bad choices,” implying that there’s nothing out there that can really create a portfolio full of truly diversified asset classes. He even goes as far as calling some of the choices rotten eggs.

“But what if all the baskets were floating in the same direction and the only one that wasn’t was filled with rotten eggs?”

To show that all the basket are floating in the same direction, he shows two tables outlining nine asset classes and their correlation to the S&P 500, one between 2003-2007, and the other from 2008-2012.

Correlation 2003 2007Correlation 2008 2012Charts Courtesy: Market Watch
(Disclaimer: Past performance is not necessarily indicative of future results)

As a refresher: the closer the correlation to 1.00, the higher the correlation, the closer to -1.00, the more negative correlation the two asset classes are, and in-between -0.30 and 0.30 is an example of a non-correlation. His argument, is that among the nine asset classes… the positive correlation to each other are growing – except for in the 20-Year US Treasury Bonds, which he argues are the rotten eggs (because we’re at the end of a 30 year bull market in bonds and prices are likely to fall).

“So, the choice appears to be throwing even more money into stocks, which are nearly five years into a bull market, or buying bonds, which we know will go down in price. Or keeping more in cash (with its negative real return) or stuffing money in the mattress. Or, God forbid, buying leveraged inverse ETFs as a “hedge.”

Now we in the managed futures space love talking non-correlation, and we really like that something like this is getting good attention… but the article is missing a rather big thing in our opinion… Managed Futures. So what does the shift in correlations look like when including managed futures. To do this we used the BarclayHedge BTOP 50 Index.

Managed Futures Correlation 2003 2007Managed Futures Correlation 2008 2012

(Disclaimer: Past performance is not necessarily indicative of future results).

Turns out managed futures has become less correlated to stocks, unlike the other asset classes (or more appropriately – more negatively correlated).  Now, that’s rather obvious from looking at the performance, where managed futures was up while stocks were down in 2008, and has been flat to down since 09 while stocks have been going straight up. (Disclaimer: Past performance is not necessarily indicative of future results).

But we don’t really agree that things are becoming more correlated as of late. Yes, they became very correlated in 2007, 2008, and 2009 – throwing off managed futures and their multi-sector diversification in the process – but since then things have been moving away from that risk on/risk off environment.  As a whole, we’ve been tracking how correlated the futures markets have been to one another, not just other asset classes (i.e. gold futures, corn futures, S&P futures, and so on) (see here, and here), and compared to the 2008-2009 numbers, the correlation has significantly decreased.

So managed futures has remained non correlated, but is that ‘basket’ full of rotten eggs just like bonds?  Not on your life. Indeed, managed futures has had nearly the inverse performance of bonds since 2009, and is at all time lows versus all time highs. The new attitude is to buy into managed futures not just because it will help your portfolio when the s^&% hits the fan, but because it isn’t likely to get much worse from here (although it could).