Diversification

TLDR

1. Diversification allows for investors to potentially reduce the risks of their portfolio while maintaining or improving the expected returns – a free lunch indeed.

2. Common methods to achieve diversification, like the 60/40 portfolio have been failing this year. With the S&P 500 down ~(25)% and the Bloomberg Aggregate Bond Index down ~(15)% (as of 09/30/22), the 60/40 Portfolio is off to its worst start since 1928 and its worst start of the 2000s by far. Its time to look for solutions elsewhere.

3. There is another way… adding Alternative Investments to a portfolio that consists of equities and bonds pushes out the efficient frontier; theoretically increasing expected returns without increasing expected volatility, picking up the slack left by the 60/40.

Introduction

In times of abundant liquidity and macroeconomic stability, we all hear stories of those who put all of their money into the hottest new tech stock, or the latest meme crypto coin, and experience huge gains, only for it to come crashing down when the markets turn. Investors can be temporarily rewarded for putting the majority of their eggs in one basket in those times of prosperity. However, in a market environment like today’s, previously hidden risks often surface, resulting in significant losses for those who are overly concentrated.

The solution to this isn’t to take on no risk altogether. Putting your cash under the mattress might give some relief from the red ticker tapes, but your purchasing power is eroded by inflation and you may miss out on upside returns when the market rebounds. Instead, we should aim to construct a portfolio that both protects capital in bad market environments and holds assets that generate attractive returns in times of prosperity.

How exactly can you do this?

The answer lies in diversification.

The Benefits of Diversification

Diversification is one of the foundational pillars of portfolio construction and a concept that the American economist and Nobel Prize winner Harry Markowitz describes as “the only free lunch in investing”. Theoretically, by using proper diversification investors are able to reduce the risk of their portfolio (as measured by volatility) while maintaining or even improving their expected return. Diversification is also rooted in the thesis that the market will not reward you (in the form of higher returns) for taking on risk that is easily avoided.

But why should you care?

Put simply, high degrees of volatility reduce the certainty of achieving your expected or target returns. To illustrate this, below we take ten randomly generated return paths using a ten-year time horizon. The first looks at a portfolio with a 7% expected return and 2% volatility, and the second is a portfolio with the same expected 7% return, but 15% volatility instead. The portfolio with the lower volatility has a much more stable set of outcomes and therefore a higher likelihood of achieving that 7% target return:

Source: Internally Generated

With that in mind, how can you start to diversify?

As mentioned above, based on the efficient market theory, investors are not rewarded for taking on risks that can be diversified away. Although individual risks are largely unforeseeable, the frequency at which they occur tends to be fairly predictable, and can be mitigated if they are spread across portfolio holdings.

Many investors recognize this and invest in mutual funds or ETFs that track broad market indices, generating market-level returns while spreading risk across companies, geographies, and sectors amongst other things. As a result, exposure to various management teams, industries, competitive forces, etc., is spread across many baskets rather than just one. This is a good start, as investors can start to negate the prevalence of idiosyncratic or concentrated risk. However, individuals are still only exposed to a small fraction of the investable universe, resulting in a high level of correlation risk. This is because the stock prices of these companies often move in the same direction, especially during periods of market stress.

The 60/40 Portfolio: Still Relevant Today?

Knowing this, investors often seek to diversify beyond equity indices to other asset classes, and in particular bonds. Theoretically, the addition of a low-correlation asset class like bonds should improve the risk/return profile of the overall portfolio. Perhaps the most famous example of this is the 60/40 Portfolio; a portfolio that consists of 60% equities and 40% bonds. This widely-utilized portfolio was based on the low to negative correlation between stocks and bonds that has existed over many decades. In other words, when equities are selling off, bonds tended to appreciate while also offering an income component, providing a cushion to your portfolio.

Despite the premise of this approach making sense, the reliability of the 60/40 is now being called into question for two reasons…

First, despite rapid financial tightening this year, nominal risk-free rates, using the 10-Year Treasury yield, are still historically low as shown in the chart below. Despite nominal yields creeping up as a result of rate hikes, real yields are still negative due to the high inflation rates, acting as a drag on portfolio returns.

Source: fred.stlouisfed.org

Secondly, the theoretical behavior of bonds exhibiting a low or negative correlation to their equity counterparts, one of the fundamental bases of the 60/40 Portfolio, is not holding true this year.

In environments such as those seen over the last 20+ years, when fundamental macroeconomic concerns were primarily that of growth slowdowns, bonds tended to rally when equities sold off, acting as a cushion to portfolios. However, when the primary macroeconomic focus has been on inflation running rampant, this correlation tends to turn positive, causing the two asset classes to sell off in unison.

Source: The Daily Shot

Additionally, when viewed from a historical lens, the negative correlation between bonds and equities is a very recent phenomenon, and there is no conclusive data to suggest that this behavior reemerges in a secular manner going forwards.

Source: Alliance Bernstein
The Role of Alternatives

So if the 60/40 Portfolio has been failing investors this year, what is one to do?

At Equi, we look to alternative investments. As it turns out, equities and bonds are just a portion of the overall investable universe, and largely ignore the world of alternative investments. Generally speaking, alternative investments include anything that doesn’t fit into traditional long-only investments in stocks, bonds, or cash. They may include private equity, real estate, private credit, or hedge funds among other things. These investments have historically exhibited a lower correlation with the broader equity markets while also offering higher return potential.

An allocation to alts works on the same underlying principles discussed earlier. Through the addition of another return stream that has low or negative correlation to the broader equity and bond markets, investors can better protect their portfolios from market drawdowns, resulting in both stronger capital preservation and higher long-term compounding of capital. But what exactly is their quantifiable impact on a portfolio?

In order to illustrate this, we can look at another foundational component of Modern Portfolio Theory, the efficient frontier. The efficient frontier represents the investment portfolios that provide the lowest expected risk, or volatility, at a given expected return. In other words, by picking a portfolio on the efficient frontier, you are able to reduce the expected volatility of your investments while still targeting the same overall return.

By adding alternative investments to a stock/bond portfolio, we are able to “push out” the efficient frontier, meaning we are able to increase the expected return of our portfolios without increasing the expected volatility:

Source: Internally Generated

Equi’s flagship portfolios are putting these principles into action. Despite the challenging environment seen this year, Equi has outperformed the index by an estimated 20%+ through September, all with lower volatility and low beta to the S&P 500.

Source: Internally Generated, Estimated YTD Performance through 09/30/22

Before Equi, most investors couldn’t access these types of investments due to their complexity and high minimums. We’re working to change that. If you would like to see how you can make alternatives a foundational pillar of your portfolio, please apply for access above.

Disclosure: This information is presented by Towards Equilibrium Inc. (“Equi”) and Equilibrium Ventures, LLC (“EquiV”) and is intended solely for informational purposes. It should not be construed as investment or trading advice and it is not meant to be a solicitation or recommendation to buy, sell, or hold any securities including funds mentioned. Any such offer or solicitation can only be made by means of the delivery of a Confidential Private Placement Memorandum, which contains a description of the significant risks involved in such an investment. Equilibrium Ventures, LLC is currently a state-registered investment adviser.

S&P 500 performance is obtained from Bloomberg. References to the S&P 500 are included for illustrative purposes only. It is not expected that the Equi funds will make investments in S&P 500 companies. The funds are expected to invest with a strategy that is different from a strategy of making equity investments across an index. Accordingly, investors should not expect that an investment in the funds would provide exposure that is similar to an index investment in S&P 500 companies or any other specific benchmark.

Net performance information is net of all Fund and investor adviser expenses and incentive fees. Returns are estimated and unaudited. The net performance information represents the return that would have been realized by a limited partner that had been invested since the beginning of the period. The actual results achieved by an investor may vary materially from these figures due to a number of factors including, but not limited to, the timing of capital activity and/or different fee arrangements. Past performance is not indicative of future results. Returns are net returns and include reinvestment of interest, capital gains and other earnings from investments. Portions of these return metrics are based on unrealized values that are expected to fluctuate over time. There can be no assurance that the fair value of such investments will be fully realizable upon their ultimate disposition. Performance of certain underlying funds are estimates because Equi is reliant on their managers for NAV and performance fees. Estimated returns have not been verified as final by Equi or any third party.

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