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).

Diversification: Giving up some home runs, to avoid future strikeouts

We love Carl Richards money doodles on the New York Times ‘Bucks’ blog, but missed this gem of a post he had at the end of last year (literally..on Dec. 31). The topic – diversification.  The angle – diversification isn’t all roses and candy canes. It’s hard to stick to because it involves giving up something (hitting home runs) in order to get something (never striking out).

Diversification bubbleDoodle Courtesy: Bucks Blog via The New York Times

At a time when stocks are at all time highs and managed futures feeling as though it’s at all time lows – it sure pays to remember what they’re doing in the portfolio – so you don’t strike out. But we’ll let the man speak for himself:

The idea [of diversification] is to balance… investments in a way that gives up some higher returns in exchange for lower overall risk. Essentially, you’ve given up the opportunity to hit home runs for the benefit of never striking out.

With that out of the way, let’s talk about the risk of diversification.

Whenever you diversify, if you’ve done it correctly, there will always be something in your portfolio that you’re in love with and something that you want to dump (or will at least be the source of concern, as bonds are now in some circles). Some investment or asset class will be doing fantastic compared to the rest of your portfolio, and something will be doing much worse than everything else.

The trouble is, you never know when all of this will change. The thing you want to buy more of now will someday become the thing you want to sell.

But here is the point. The risk of diversification is that you will bail on it as a strategy at exactly the wrong time.

That feeling you get — the one that says, I wish I could dump this lame investment so I could buy a whole bunch more of this incredibly hot one — can get you into trouble fast. The temptation is greatest when it would be the most catastrophic for you to succumb.

But that feeling is actually telling you that you’ve done the right thing: You’re diversified. So remember that when the current fad ends and today’s rejects come back into style, you’ll be okay. And you’ll be awfully glad you didn’t give in to the temptation to give up on being diversified.

The next time diversification appears to not be working, remind yourself that it is a long-term strategy that can’t be judged on your short-term experience. In other words, just because something isn’t working right this minute — or even right this year — doesn’t mean it’s broken. So instead of thinking, “I am a rocket scientist and I can come up with something better,” just let diversification do its job.

Then go for a hike in the mountains instead of sitting hunched over the sell button on your broker’s Web site.”


Did he just say that Diversification was broken?

We’ve been starting to see more and more of this lately…. People eschewing diversification for the big returns from being fully invested in the stock market. Add that to the questionable investments lately (Football player’s success) and the margin debt at the NYSE moving into bubble territory, and it’s starting to look a bit frothy out there.

But let’s tackle the diversification is broken theme for a minute, articulated in a recent piece by John Authers titled “This is no time to get off the equity train.” The first paragraph lays it out there quite clear (emphasis ours).

 “At present, stock markets continue to charge uphill. That is good for those who are on board, but horrible for anyone who has gone out of their way to diversify. Diversification looks bad when it turns out you don’t need it.”

That’s a harmless enough statement in and of itself. A lifejacket looks silly when you don’t need it. A seatbelt is a little uncomfortable when you don’t need it. And insurance is expensive when you don’t need it. We couldn’t agree more. But Mr. Auther’s starts to take it in a bit of a different direction as he goes on with his piece, calling out a poster child for portfolio diversification and the heavy use of alternative investments: Yale’s endowment:

Yale University’s endowment, under the leadership of David Swensen, upended conventional thinking on diversification some two decades ago. Mr Swensen argued that he was most likely to find value away from the public markets. Private markets were more likely to be inefficiently priced, and therefore offer bargains. He moved out of bonds and cash, and into hedge funds, private equity and real assets such as forestry. Yale now holds about 6 per cent of its assets in US equities. This reaped impressive returns for decades, and many endowments imitated it.

But this diversification could not stop Yale from suffering a loss during the financial crisis period of 2008-09. Since then, the stock market boom has not flattered endowments.”

The logic here that having as little as 6% in equities “reaped impressive returns for decades” but then suffered a loss during the 2008-2009 period is somehow a bad thing is missing the forest for the trees,  in our opinion.

Yale’s endowment reported a 4.5% return in 2008, and a -24.6% in 2009, but those are Fiscal Years, ending in June 30 of each year. So the -24.6% loss in Fiscal Year 2009 was actually between July 2008 and June 2009, which is nearly exactly the height of the financial crisis, where the S&P 500 was down -28.4% over that period. Not sure about you, Mr. Authers, but we would much rather have that -24.6% versus the -28.4%. Oh, and there’s the little point worth mentioning that the 2009 loss followed 19 consecutive years of gains (when the S&P 500 had six annual losses over the same period).

Yale Endowment Performance

Source: Yale Endowment
(Disclaimer: Past performance is not necessarily indicative of future results)

Next up, the argument that the traditional 60% stocks/40% bonds split is better than full diversification.

“Figures for 2011-12, when stocks also fared well, are drab. Yale made 4.7 per cent, but the average US endowment dropped 0.3 per cent, while the S&P gained 5.5 per cent. A combination of 60 per cent in stocks and 40 per cent in bonds, which is the way most endowments managed their money before the Yale revolution, would have risen 6.3 per cent.”

We wouldn’t recommend investors base decisions on a single year, ever. One year does not make a track record. And if we look at the ten years, from Jan 2003 to present, the Yale Endowment would have a 117% total return, versus a 60/40 portfolio having a total return of 57%, (we used the S&P 500 at 60% for stocks, and the Barclay Bond Aggregate index for bonds at 40%).

Yale vs. 60 40 (1)(Disclaimer: Past performance is not necessarily indicative of future results)
(Disclaimer: Yale Endowment does not include this year’s returns)

Again, not sure about you, Mr. Authers, but +117% versus +57% shows us that diversification into more than just bonds is working quite well for Yale – to the tune of twice as well over the last 10 years.  But that may be what Authers is really getting at, as his closing lines talk about Yale’s returns being more about Swensen being early to the alternatives/private equity movement, versus their benefit as diversifiers, and that he is reducing the private equity exposure because of that:

“Mr Swensen himself is reducing his allocation to private equity. Many of his buys were a one-off opportunity – to buy assets when they were not understood and when skilled managers were available to take advantage of mispricings. That opportunity no longer exists. As “me-too” investors crowded in, markets grew more efficient and returns dwindled – but the wave of imitators did help push up Yale’s performance.”

That argument is a little over our pay grade (and research budget) – not being private equity folks – but we can argue that it is unfair to implicate all of the alternatives space based on that same logic. And to be fair, Authers isn’t implicating all alternatives – he seems to be just calling out private equity here, saying the opportunity for private equity to managers to “take advantage of mispricings” no longer exists. (a big claim with the billions and billions of dollars current in Private Equity – but he’ll have to defend that on his own).

And Authers does save himself from jumping on the ‘diversification isn’t needed’ crazy train in his conclusion, saying:

That does not mean that the case for diversification has vanished. Conditions like those of the past five years are unlikely to be repeated very often. But the case is not to buy what Yale bought two or three decades ago. Rather, it is to apply the same process, look for assets that may be inefficiently priced and would not fall with equities, and to buy those.

That process should still work when, as is inevitable, stocks at last lose their momentum.”

We can argue on his semantics there, in that it is more important to find asset classes with different return drivers (which leads to them not falling with equities) rather than assets which are inefficiently priced, but that may be splitting hairs – and at the end of the day we’re thankful he realizes the inevitability of stocks, “at last” losing their momentum.