Multi-Dimensional Diversification - Improving on Conventional Diversification

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Dan Irvine  |  Principal
3Summit Investment Management, LLC
May 2017


Summary

  • Conventional portfolio diversification does little to control overall investment risk as a 60/40 portfolio results in a 97.5% correlation to stocks since 1972.
  • High quality portfolio management decisions can only be made when risk is decomposed in a consistent process that is quantifiable and logical. A Multi-Dimensional Diversification framework provides superior diversification and investment risk control.

Taking a closer look at portfolio diversification

The word diversification is one of the most commonly used words in the investment management industry. Investors, advisors and market pundits universally use the word diversification as a catch all to explain the process of managing risk in an investment portfolio. Diversification is complex; simply allocating portfolios across many asset classes (stocks, bonds, commodities etc.) and securities does not necessarily equate to a high level of risk control.

The majority of investment portfolios use the most basic form of diversification in that they are designed to hold many asset classes and many individual securities within each asset class. The logic behind this approach is that if any one asset class or individual security struggles with poor performance, the others in the portfolio will hopefully neutralize the negative impact. This approach is sound in theory, and can in practice lower the overall risk within a portfolio. However, the quality of risk control achieved through conventional diversification is inadequate because most portfolios are still left almost completely exposed to equity risk (stock market risk). Therefore, most conventional portfolios will perform almost entirely in-line with stocks, regardless of how the other asset classes and securities perform.

The conventional investment portfolio

The common belief in portfolio construction is that stocks are risky (prices are volatile and can fluctuate greatly) and bonds are less risky (prices are less volatile and do not fluctuate much). Additionally, during many different time frames stocks and bonds have a low to negative correlation with each other enhancing the perceived diversification benefits. Given these asset class observations, the conventional wisdom regarding portfolio construction is that to reduce the portfolio risk from volatile stocks, an allocation to lower volatility, less correlated bonds should be made as an offset.  This thinking leads to the conventional “60/40” portfolio (60% stocks/40% bonds) or some other materially similar allocation. The irony of the conventional portfolio is that the very asset class attributes, which are used to rationalize the conventional allocation, in practice actually undermine the risk controls they are meant to provide.  Looking at historical performance going back to 1972, the conventional 60/40 portfolio has had a 97.5% correlation to the stock market!  These results suggest that there is little to no diversification benefit to be gained from the conventional diversification approach. There are two reasons conventional diversification is not effective:

1.    Bonds are much less volatile than stocks
2.    Different asset classes have different economic biases

Diversification Problem 1: Bonds are much less volatile than stocks

Historically, stocks have had an average volatility of approximately 15% and intermediate government bonds have had an average volatility of approximately 6%. If stocks fall -15% in a period and bonds rise approximately 6% during the same period (assuming perfect negative correlation), the period return in a 60/40 portfolio would be -6.6%. In this example, the relatively low volatility of bonds limited the magnitude of the positive returns of the bonds in the portfolio compared to the much more volatile stocks and therefore did little to mitigate investment losses. When you further consider the smaller allocation size of bonds relative to stocks, the bonds could not provide much downside protection. This example illustrates that the volatility mismatch of the two asset classes limit the diversification benefits they can provide each other.

Diversification Problem 2: Different asset classes have different economic biases

There are two economic factors that have the greatest impact on financial markets, growth and inflation. The direction of each of these economic factors together create four distinct economic conditions referred to as economic regimes (see Figure 1 below). Each asset class is biased to out-perform in different economic regimes. Expanding on Figure 1, Figure 2 shows during which economic regime each of the primary asset classes are biased to out-perform. 

Figure 2

Figure 1

Most conventional 60/40 portfolios benchmark the stock allocation to the S&P 500 and the bond allocation to the Barclays US Aggregate. Applying these benchmark assumptions to economic regimes, Figure 3 below shows the risk weighted exposure that the conventional 60/40 portfolio carries to each economic regime.

Figure 3

Figure 3.png

What becomes immediately obvious from Figure 3 is that the portfolio is dominated by equity risk (stock market risk) because the portfolio is almost completely exposed to the rising growth/falling inflation economic regime, which is the economic environment stocks perform best. Only 10% of the economic risk is diversified in the falling growth/rising inflation economic regime. This is not an economically diversified portfolio and carries no protection at all against rising inflation.It can easily be seen why historically the 60/40 portfolio has been 97.5% correlated to the stock market given the dominant exposure to equity-like risk! 

Multi-Dimensional Portfolio Diversification Framework

At 3Summit we view risk management and asset allocation though our proprietary Multi-Dimensional Diversification framework, which provides for maximum control of investment risk.

Figure 4

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All custom 3Summit portfolios are constructed with total awareness of the first dimension of investment risk – economic risk. Asset class allocation has the greatest impact on total portfolio risk, therefore ensuring economic diversification is the first dimension in our Multi-Dimensional Portfolio Diversification framework. We start the construction of all portfolios from a risk balanced position (see Figure 5), which simply means the portfolio is exposed equally on a risk weighted basis to each economic regime. 

Figure 5

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Next, we seek to adjust the risk balance based on what is appropriate for an individual’s specific financial situation, risk tolerance and investment objectives.  Perfect balance of risk between economic regimes is not required, especially if an investor seeks higher returns than a balanced portfolio is likely to produce, in which case the need to take additional economic risk may be required. Finally, a long-term plan to move from perhaps a less economic risk balanced position to a more economic risk balanced position is created as clients approach their investment targets and their time horizon decreases.

Once the economic risk balance targets have been defined, the asset class allocation targets are also defined as they are a product of the economic risk balance decision. With the asset class allocation targets defined, the final two dimensions of the Multi-Dimensional Diversification framework are implemented: Global Diversification and Investment Strategy Diversification.

The second dimension of Multi-Dimensional Portfolio Diversification is Global Diversification, which diversifies the portfolio across global financial markets, ensuring the portfolio is not exposed to only one financial market, business cycle or political system.  Global exposure is also very important because about half of all investment opportunities are outside of the United States; thus, global portfolios have a much larger investment opportunity set and we seek to fully exploit this advantage for clients.

Finally, the third dimension of Multi-Dimensional Portfolio Diversification is Investment Strategy Diversification. The goal of this dimension is to diversify the sources of investment returns within a portfolio. Multi-strategy investing means investing across multiple distinct investment strategies within the same asset class, each of which have different sources of returns as indicated by low correlations of excess returns. Low correlation of excess returns signals that the strategies being compared tend to out-perform at different times. When one strategy is under-performing, another is likely out-performing. 

We manage sophisticated institutional quality investment strategies and because each strategy targets a unique source of investment returns the objective of the multi-strategy approach is to stabilize returns within an asset class by combining complimentary strategies.

The end result of our custom investment portfolio construction process using our Multi-Dimensional Diversification framework is a highly sophisticated, highly diversified portfolio, purpose built to meet unique investment objectives within the confines of individual risk tolerances.

Why are the vast majority of investment portfolios based on the conventional diversification approach?

There are many reasons investors continue to hold conventional portfolios and remain exposed to concentrated economic risk. Below is a list of the most common reasons:

1.    Conventional diversification, or the “60/40” portfolio, is so ubiquitous investors are often not comfortable with the much different asset class allocations required to balance risk.

2.    Some investors seek high return potential and are willing to take on highly concentrated risks.

3.    Multi-Dimensional Portfolio Diversification is complex because the process requires a lot of data and is a quantitative approach to portfolio management. The complexity requires sophisticated custom portfolio management systems which cannot be purchased “off the shelf” from any software vendors.

4.   Multi-Dimensional Portfolio Diversification can only be implemented within a custom portfolio, and most advisors do not have the technical capabilities to manage large numbers of unique portfolios. 

5.    Investment advisors tend to maintain the status-quo within investment management because they are not incentivized to make enhancements.

High quality portfolio management decisions can only be made when risk is decomposed in a consistent process that is quantifiable and logical.  For many investors, the approach to diversification and risk control detailed in this paper may be a new concept. It is important that every investor understand the potential sources of investment risk in their portfolio so they can accurately assess the quality of their diversification. Furthermore, understanding a portfolios sources of risk can help investors understand why a portfolio may be under-performing in certain markets and help them stay to the course with their investment plan. The number one determinants of investment success is the ability to stay the course in difficult markets, and knowledge greatly reduces the courage needed to weather difficult markets. 

Whether you chose to use the diversification framework we have outlined, or a method that aligns more closely to how you understand market risk, there is no “correct” way to manage risk. All that matters is you have a comprehensive, consistent and significantly robust strategy.