“There is nothing new under the sun.” So says the Book of Ecclesiastes. Its investment advice might be less well known, but it bears the more famous quotation out:
“But divide your investments among many places, for you do not know what risks might lie ahead.”
– Ecclesiastes 11:2 – New Living Translation
So the concept of diversification is nothing new. But investors may be less aware of the risk entailed by the diversification process itself. Simply put, this is the risk that we buy bad things because they are ‘good diversifiers’.
It’s instructive to look at the performance of major asset classes over the past decade. And, if you’re able to recall what you were thinking at the time, it can also be chastening. In 2006, for example, how many of us thought that property would lose more than a quarter of its value over the next couple of years? And in 2007, how many were convinced that commodities and emerging markets were enjoying a booming ‘super cycle’? More than would care to admit it, I suspect.
This tells us that our expectations of future returns may well be very, very wrong. And it should warn us that our diversifiers may not provide the expected protection. Simply putting investments “among many places”, purely for that reason, may not work.
In 1952, Harry Markowitz refined Ecclesiastes’ concept of diversification somewhat further:
“To reduce risk it is necessary to avoid a portfolio whose securities are all highly correlated with each other. One hundred securities whose returns rise and fall in near unison afford little [more] protection than the uncertain return of a single security.”
Before Markowitz shook things up, portfolio-management theory was limited to picking the highest-quality stocks with the best expected returns. Markowitz pointed out that this would logically concentrate funds in a few assets with the greatest expected returns. It was better, he argued, to combine assets with prices that rose or fell at different times – that is, assets that have a low correlation with each other. And he showed that this could be done without sacrificing the portfolio’s expected return.
This has become one of the building blocks of investment theory. But in 1952 it was revolutionary. What Markowitz did with his Modern Portfolio Theory was to offer the investment world’s only free lunch. It’s certainly proven popular since. But it’s also now less nourishing. Following the global financial crisis, asset correlations have increased sharply. And since 1997, the correlation of equity, bond and commodity indices has more than doubled – with their diversification benefits decreasing accordingly.
High levels of correlation usually point to common sources of risk. It may be fair to say that some of the recent increases in correlations are ‘cyclical’, reflecting the unusual monetary environment in which we now find ourselves. Governments have pushed risk-free yields (the theoretical return from an asset with zero risk) down and prices up, through their various versions of quantitative easing, which in turn is encouraging investors to buy riskier assets, pushing their prices up also. However, there are also more ‘secular’ reasons for increased correlations given the growing integration of the global economies and the increased efficiency and sophistication of financial markets.
Investors should be sceptical of anything that promises – like commodities in the 2000s – to defy market gravity.
However, one of the greatest risks to the tastiness of the diversification ‘free lunch’ is buying poor assets. Let’s consider commodities. By 2000, China was starting to make its economic presence felt. Global growth was strong, and there were huge changes in emerging markets as their middle classes became increasingly wealthy and aspirational.
The consequent impact on demand for commodities made commodity producers the darlings of the stock market, and people started to talk about a ‘super cycle’.
Meanwhile, in the investment business, we decided that commodities were an ‘asset class’ in their own right, rather than just useful materials used by constructors and manufacturers. Between 2000 and 2007, commodities were seen as ‘diversifiers’ – diversifiers whose prices only went up. And this was correct – until, suddenly, it wasn’t.
End of the commodity ‘super cycle’
Source: Bloomberg (USD) as at 11/04/2016
I often think of the commodity crash when I hear that something is a ‘good diversifier’. It may be, but is it a good investment? Diversification into commodities may have theoretically reduced risk, but it also reduced wealth.
So, with this in mind, where are we now? In today’s highly correlated world, where are the opportunities and what are the risks? Which asset class will be the ‘new commodities’ by 2021? This should be front of mind when one looks at ‘alternative’ asset classes.
Many of today’s array of non-traditional assets look useful for diversification purposes. But there are also dangers. It used to be fashionable to wrap up low-yielding assets in leveraged vehicles, which – as if by magic – became high-yielding assets. These toxic assets were at the heart of the financial crisis. So beware investible wolves in high-yielding sheep’s clothing – there are an increasing number of them around.
That caveat aside, there are some interesting asset classes out there. High yield often offers good value and can be a good asset to buy from the fearful – but always remember that these were called ‘junk bonds’ before their ‘makeover’ – so homework needs to be done. ‘Real assets’, such as property and infrastructure, are also promising, because they can generate high-quality cash flows from physical assets, and can fulfil a real need in many of the countries where these opportunities lie.
Then there are investments characterised by very low economic sensitivity. These include absolute-return and active currency strategies, insurance-linked securities and trend-following future strategies. Here, it’s important to ensure that you get skill and value for money from your manager. It’s always worth asking that hoary old question: where are the customers’ yachts?
Overall, although we have a more complex correlation environment, we also have more choice than we had even 10 years ago. That allows us to build portfolios with far less reliance on the old equity bond split. And, crucially, it allows those portfolios to be less susceptible to the higher correlations between major asset classes. Markowitz’s ‘free lunch’ is still on the table, but you need to read the menu carefully to avoid indigestion.
The best advice, then, is to stick with well-resourced investment teams that have the skills, time and experience to research these asset classes inside out. Above all, investors should be sceptical of anything that promises – like commodities in the 2000s – to defy market gravity. In that regard, the Book of Ecclesiastes is right: there really is nothing new under the sun.
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