Morningstar Advisor - June/July 2013 - (Page 36)
Spotlight
Beware the Lure of Diversification
By Michael Coop
To truly diversify a traditional portfolio, alternative investments
need to be cheap and behave differently than stocks and bonds.
Much like the Greek sailors who were lured
to shipwreck by the enchanting music
and voices of the Sirens, investors have been
seduced by the call of diversification into
buying overvalued, cyclical strategies marketed
as alternative investments and paying high
fees to obtain them.
The superior performance of commodities,
infrastructure assets, and hedge funds over
equities during the 2000–2002 bear market
attracted a lot of capital to these areas
in ensuing years. But all performed far worse
during the global financial crisis of 2008
than they did in the earlier downturn; losses for
commodities and infrastructure were on par
with those of equities (Exhibit 1).
Adding these assets to a traditional stock/bond
portfolio barely improved the portfolio’s
performance. From 2000 to 2012, diversifying
into alternatives would have increased returns
by a meager 0.2% annualized and not
reduced risk (based on a 10% allocation equally
split between hedge funds, infrastructure,
and commodities, funded pro rata for a 50%
equity/50% bond portfolio).
This outcome is a far cry from what most
investors expect when they use alternative
investments as diversifiers. Adding them
to a traditional portfolio is supposed to improve
outcomes in ways that would not be possible
simply by varying the mix of stocks and
bonds. The aim is to improve risk-adjusted
returns, so that for a given amount of risk,
returns should be higher, or for a given return,
risk should be lower.
Two Conditions of Diversification
The risk investors should be most concerned
with is the permanent loss of capital
rather than volatility. For diversification
to work, an alternative investment must meet
two conditions:
1. It needs to behave differently from equities
and bonds over a full market cycle.
Whatever drives alternatives’ underlying cash
flows and changes in valuation cannot be
the same drivers of the behaviors of equities
and bonds.
2. It should be priced low enough to generate a
return high enough to improve the portfolio’s
performance, taking into account valuation and
fees. An alternative investment’s returns
do not need to be higher than those of equities
or bonds, providing the investment does
behave differently. But adding it won’t improve
1 Ibbotson, Roger G. and Peng Chen, “Long Run Stock Returns: Participating in the Real Economy,” 2003
36 Morningstar Advisor June/July 2013
total portfolio outcomes if it suffers a large fall
in value, as tends to happen after surges in
popularity and prices.
Is It Really Alternative?
The first condition for getting diversification
is very important; many funds are promoted
as alternative investments but there
is no widely accepted definition of “alternative.”
Investors need to understand what drives
the prices of equities and bonds before they
can determine if the alternative investment
is giving them more of the same, or
something different. When equities and bonds
suffer large losses, will the alternative
investment behave the same way or will
it provide the needed diversification at that
time? Let’s look at some drivers of equity and
bond returns.
Equity Returns
Dividends and corporate earnings per share
have been the key drivers of real equity returns
over the long term.1 Income comes from
dividends; capital return comes from changes
in share prices, reflecting 1) inflation,
2) growth in corporate earnings that accrues
to shareholders, and 3) changes in valuation
(for example, how much investors pay for
future cashflows).
Table of Contents for the Digital Edition of Morningstar Advisor - June/July 2013
Morningstar Advisor - June/July 2013
Contents
Contributors
Letter From the Editor
Not Your Values
How Do You Use Alternatives for Clients?
Working to Build a Niche
How to Put Buffett’s Investing Philosophy into Practice
Sophisticated Strategies for the Masses
Investments á la Carte
Investment Briefs
The Percentile Trap
Defense Firms Will Stay Aloft
Beware the Lure of Diversification
Using Alternatives in Practice
Managed Futures and Cash Rates
The World Is Getting Grayer
Waiting to Pull Up Anchor
The Price of Managing Volatility
Let’s Get Back to Basics
Our Favorite Mutual Funds
50 Most-Popular Equity ETFs
Undervalued Stocks With Wide Moats
Mutual Fund Urban Myths
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