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Serving Up Diversification

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When Assets Are More Correlated Than Expected

For decades the finan­cial indus­try has pro­mot­ed diver­si­fi­ca­tion as the most log­i­cal, pru­dent way to max­i­mize returns and min­i­mize risk. How­ev­er, in order to tru­ly reap the ben­e­fits of diver­si­fi­ca­tion, a strate­gic invest­ment plan must be imple­ment­ed cor­rect­ly.

With­out prop­er imple­men­ta­tion, diver­si­fi­ca­tion will like­ly not yield its pur­port­ed ben­e­fits.

 

Diversification Strategies: Tried, But Perhaps Not So True…

For many investors, diver­si­fi­ca­tion meant invest­ing across a wide array of invest­ment styles or asset class­es. Fre­quent­ly some sort of opti­miza­tion algo­rithm was uti­lized to max­i­mize the trade-off between expect­ed returns and expect­ed risks. Lynch­pin to this approach is the key role that cor­re­la­tion plays in the equa­tion. The ben­e­fits of diver­si­fi­ca­tion are real­ized only if the invest­ments tru­ly behave dif­fer­ent­ly from one anoth­er.

Unfor­tu­nate­ly, many investors pur­sued “false diver­si­fi­ca­tion”, or a diver­si­fi­ca­tion strat­e­gy that involved sim­ply ‘slic­ing and dic­ing’ the mar­ket.

False Diversification

One wide­ly fol­lowed form of false diver­si­fi­ca­tion was to slice up the mar­ket into small­er and small­er pieces while neglect­ing to move the eggs out of the prover­bial bas­ket.

As the chart below dis­plays, ini­tial­ly, investors divid­ed equi­ty mar­kets into large cap and small cap “styles”. Next, a val­ue and growth dis­tinc­tion was made. Even­tu­al­ly, the con­cepts of mid-cap and core were added to the style mix.

Split­ting the hairs even fur­ther, con­cepts like mega-cap, micro-cap, “SMID”-cap, deep val­ue, rel­a­tive val­ue, growth-at-a-rea­son­able-price, and momen­tum-growth were all incor­po­rat­ed into the con­cept of diver­si­fi­ca­tion. How­ev­er, none of these styles were tru­ly new assets: they were sim­ply small­er slices of the same pie.

Slicing the Market - False Diversification | Swan Global Investments - Blog

Real Portfolio Diversification Requires a Lack of Correlation

As not­ed above, true diver­si­fi­ca­tion is achieved when two or more invest­ments exhib­it dif­fer­ent respons­es to mar­ket moves.

The table below shows how high­ly cor­re­lat­ed all of these styles, or slices of the mar­ket pie, are to one anoth­er. Cor­re­la­tions between +0.80 and +0.90 are high­light­ed in yel­low, between +0.90 and +0.95 in orange and above +0.95 in red.

No two styles have cor­re­la­tions less than +0.80, severe­ly lim­it­ing the diver­si­fi­ca­tion poten­tial of these invest­ments.

Style Correlations and False Diversification - Swan Global Investments - Blog

See below for definitions of these Style Correlations

Investors with assets across each of these “styles” prob­a­bly felt great when mar­kets were going up and like­ly assumed diver­si­fi­ca­tion was work­ing as adver­tised. But the sim­ple and neglect­ed truth was that if every­thing was going up at the same time, they would very like­ly all go down at the same time. And of course, that’s exact­ly what hap­pened.

Even investors who moved into oth­er asset class­es like inter­na­tion­al stocks, emerg­ing mar­ket stocks, high yield bonds, real estate, and com­modi­ties saw those invest­ments plunge in lock-step with their US equi­ty invest­ments dur­ing the 2008 cri­sis. When port­fo­lio diver­si­fi­ca­tion was need­ed most, the cor­re­la­tions spiked. The two tables below dis­play how cor­re­la­tions shift­ed from their long-term aver­ages dur­ing the cri­sis of 2008:

Long-Term vs Crisis Correlations - False Diversification | Swan Global Investments - Blog

The damp­en­ing of a portfolio’s over­all volatil­i­ty is only pos­si­ble if the con­stituents of a port­fo­lio have low or, ide­al­ly, neg­a­tive cor­re­la­tions. In a fol­low-up blog post, we will explore the math­e­mat­i­cal under­pin­nings of cor­re­la­tion. Suf­fice it to say, a well-con­struct­ed diver­si­fi­ca­tion strat­e­gy should have loss­es in one por­tion of the port­fo­lio off­set by gains in anoth­er.

 

How are you serving up portfolio diversification for your clients?

Swan Glob­al Invest­ments’ Defined Risk Strat­e­gy (DRS) was designed to be a bet­ter way to imple­ment diver­si­fi­ca­tion. The DRS is com­posed of three com­po­nents: equi­ty, hedge, and income. The hedge, imple­ment­ed via put LEAPS, is neg­a­tive­ly cor­re­lat­ed to the direc­tion of the equi­ty por­tion. The income gen­er­at­ed by the sale of option pre­mi­um is designed to be mar­ket-neu­tral and uncor­re­lat­ed to the market’s direc­tion. For a more thor­ough dis­cus­sion of how the DRS seeks to diver­si­fy its sources of return click here.

 

 

About the Author:

Marc Odo, CFA®, CAIA®, CIPM®, CFP®, Director of Investment Solutions - Swan Global InvestmentsMarc Odo, CFA®, CAIA®, CIPM®, CFP®, Client Port­fo­lio Man­ag­er, is respon­si­ble for help­ing clients and prospects gain a detailed under­stand­ing of Swan’s Defined Risk Strat­e­gy, includ­ing how it fits into an over­all invest­ment strat­e­gy. For­mer­ly Marc was the Direc­tor of Research for 11 years at Zephyr Asso­ciates.

 

Definitions of Style Correlations

The Rus­sell Top 200® Index mea­sures the per­for­mance of the largest cap seg­ment of the U.S. equi­ty uni­verse. The Rus­sell Top 200 Index is a sub­set of the Rus­sell 3000® Index. It includes approx­i­mate­ly 200 of the largest secu­ri­ties based on a com­bi­na­tion of their mar­ket cap and cur­rent index mem­ber­ship and rep­re­sents approx­i­mate­ly 68% of the U.S. mar­ket.

The Rus­sell Top 200® Index mea­sures the per­for­mance of the largest cap seg­ment of the U.S. equi­ty uni­verse. The Rus­sell Top 200 Index is a sub­set of the Rus­sell 3000® Index. It includes approx­i­mate­ly 200 of the largest secu­ri­ties based on a com­bi­na­tion of their mar­ket cap and cur­rent index mem­ber­ship and rep­re­sents approx­i­mate­ly 68% of the U.S. mar­ket.

The Rus­sell Top 200® Val­ue Index mea­sures the per­for­mance of the espe­cial­ly large cap seg­ment of the U.S. equi­ty uni­verse rep­re­sent­ed by stocks in the largest 200 by mar­ket cap that exhib­it val­ue char­ac­ter­is­tics. It includes Rus­sell Top 200 com­pa­nies that are con­sid­ered more val­ue ori­ent­ed rel­a­tive to the over­all mar­ket as defined by Russell’s lead­ing style method­ol­o­gy.

The Rus­sell Mid­cap Index mea­sures the per­for­mance of the mid-cap seg­ment of the U.S. equi­ty uni­verse. The Rus­sell Mid­cap Index is a sub­set of the Rus­sell 1000® Index. It includes approx­i­mate­ly 800 of the small­est secu­ri­ties based on a com­bi­na­tion of their mar­ket cap and cur­rent index mem­ber­ship.

The Rus­sell Mid­cap Growth Index mea­sures the per­for­mance of the mid-cap growth seg­ment of the U.S. equi­ty uni­verse. It includes those Rus­sell Mid­cap Index com­pa­nies with high­er price-to-book ratios and high­er fore­cast­ed growth val­ues.

The Rus­sell Mid­cap Val­ue Index mea­sures the per­for­mance of the mid-cap val­ue seg­ment of the U.S. equi­ty uni­verse. It includes those Rus­sell Mid­cap Index com­pa­nies with low­er price-to-book ratios and low­er fore­cast­ed growth val­ues.

The Rus­sell 2000 Index mea­sures the per­for­mance of the small-cap seg­ment of the U.S. equi­ty uni­verse. The Rus­sell 2000 Index is a sub­set of the Rus­sell 3000® Index rep­re­sent­ing approx­i­mate­ly 10% of the total mar­ket cap­i­tal­iza­tion of that index. It includes approx­i­mate­ly 2000 of the small­est secu­ri­ties based on a com­bi­na­tion of their mar­ket cap and cur­rent index mem­ber­ship.

The Rus­sell 2000 Growth Index mea­sures the per­for­mance of the small-cap growth seg­ment of the U.S. equi­ty uni­verse. It includes those Rus­sell 2000 com­pa­nies with high­er price-to-val­ue ratios and high­er fore­cast­ed growth val­ues.

The Rus­sell 2000 Growth Index mea­sures the per­for­mance of the small-cap growth seg­ment of the U.S. equi­ty uni­verse. It includes those Rus­sell 2000 com­pa­nies with high­er price-to-val­ue ratios and high­er fore­cast­ed growth val­ues.

The Rus­sell 3000 Index mea­sures the per­for­mance of the largest 3,000 U.S. com­pa­nies rep­re­sent­ing approx­i­mate­ly 98% of the investable U.S. equi­ty mar­ket.

The Rus­sell Micro­cap® Index mea­sures the per­for­mance of the micro­cap seg­ment of the U.S. equi­ty mar­ket. Micro­cap stocks make up less than 3% of the U.S. equi­ty mar­ket (by mar­ket cap) and con­sist of the small­est 1,000 secu­ri­ties in the small-cap Rus­sell 2000® Index, plus the next 1,000 small­est eli­gi­ble secu­ri­ties by mar­ket cap.

The Rus­sell Micro­cap® Growth Index mea­sures the per­for­mance of the micro­cap growth seg­ment of the U.S. equi­ty mar­ket. It includes Rus­sell Micro­cap com­pa­nies that are con­sid­ered more growth-ori­ent­ed rel­a­tive to the over­all mar­ket as defined by Russell’s lead­ing style method­ol­o­gy.

The Rus­sell Micro­cap® Val­ue Index mea­sures the per­for­mance of the micro­cap val­ue seg­ment of the U.S. equi­ty mar­ket. It includes Rus­sell Micro­cap com­pa­nies that are con­sid­ered more val­ue-ori­ent­ed rel­a­tive to the over­all mar­ket as defined by Russell’s lead­ing style method­ol­o­gy

The MSCI EAFE Index is a mar­ket-cap­i­tal­iza­tion weight­ed, stock mar­ket index that is designed to mea­sure the equi­ty mar­ket per­for­mance of devel­oped mar­kets out­side of the U.S. & Cana­da. It is main­tained by MSCI Bar­ra, [1] a provider of invest­ment deci­sion sup­port tools; the EAFE acronym stands for Europe, Aus­trala­sia and Far East.

The MSCI Emerg­ing Mar­kets Index cap­tures large and mid cap rep­re­sen­ta­tion across 23 Emerg­ing Mar­kets (EM) coun­tries*. With 838

con­stituents, the index cov­ers approx­i­mate­ly 85% of the free float-adjust­ed mar­ket cap­i­tal­iza­tion in each coun­try.”

The Bar­clays U.S. Cor­po­rate High Yield index mea­sures the mar­ket of USD-denom­i­nat­ed, non-invest­ment grade, fixed-rate, tax­able cor­po­rate bonds. Secu­ri­ties are clas­si­fied as high yield if the mid­dle rat­ing of Moody’s, Fitch, and S&P is Ba1/BB+/BB+ or below.

The FTSE NAREIT All REITs Index is a mar­ket cap­i­tal­iza­tion-weight­ed index that includes all tax-qual­i­fied real estate invest­ment trusts (REITs) that are list­ed on the New York Stock Exchange, the Amer­i­can Stock Exchange or the NASDAQ Nation­al Mar­ket List. The Index is not free float-adjust­ed and con­stituents are not required to meet min­i­mum size and liq­uid­i­ty cri­te­ria.

The S&P GSCI is a com­pos­ite index of com­mod­i­ty sec­tor returns which rep­re­sents a broad­ly diver­si­fied, unlever­aged, long-only posi­tion in com­mod­i­ty futures.

sources: www.russell.com, www.investopedia.com

Impor­tant Dis­clo­sures

Swan offers and man­ages the pro­pri­etary Defined Risk Strat­e­gy (“DRS”) for its clients includ­ing indi­vid­u­als, insti­tu­tions and oth­er invest­ment advi­sor firms. Swan’s DRS per­for­mance results here­in are of the DRS Select Com­pos­ite which includes all non-qual­i­fied accounts. Addi­tion­al infor­ma­tion regard­ing Swan’s com­pos­ite poli­cies and pro­ce­dures for cal­cu­lat­ing and report­ing per­for­mance returns is avail­able upon request. All Swan per­for­mance results have been com­piled sole­ly by Swan Glob­al Invest­ments and are unau­dit­ed. Oth­er per­for­mance return fig­ures indi­cat­ed in this mate­r­i­al are derived from what Swan believes to be reli­able sources (i.e., S&P 500 index, oth­er index­es and bench­marks), but Swan does not guar­an­tee its reli­a­bil­i­ty. This analy­sis is not a guar­an­tee or indi­ca­tion of future per­for­mance. Invest­ments in for­eign secu­ri­ties involve addi­tion­al risks includ­ing cur­ren­cy risk. Ref­er­ences to the S&P 500 and oth­er indices and bench­marks are for infor­ma­tion­al and gen­er­al com­par­a­tive pur­pos­es only. Index­es are unman­aged and have no fees or expens­es. An invest­ment can­not be made direct­ly in an index. The adviser’s depen­dence on its DRS process and judg­ments about the attrac­tive­ness, val­ue and poten­tial appre­ci­a­tion of par­tic­u­lar invest­ments, ETFs and options in which Swan invests or writes may prove to be incor­rect and may not pro­duce the desired results. Swan Glob­al Invest­ments, LLC, Swan Cap­i­tal Man­age­ment, LLC, Swan Glob­al Man­age­ment, LLC and Swan Wealth Man­age­ment, LLC are affil­i­at­ed enti­ties.   Fur­ther infor­ma­tion is avail­able upon request by con­tact­ing the com­pa­ny direct­ly at 970–382-8901 or www.swanglobalinvestments.com. 017- 032-SGI-042715

 

By |2018-10-02T15:07:57+00:00July 29th, 2015|Blog|Comments Off on Serving Up Diversification