Capital versus Risk Allocation – what most investors get wrong with diversification - January 2017

There is one aspect of investing that most retail and institutional investors get wrong, a lot, and that is diversification. We see it all the time. While it starts in a place of diligent thought and effort, it is important to recognize that diversification, as many understand it, expresses an old approach to investing that may not actually shield investors as intended. Even though portfolios are typically built on the basis of diversifying capital across assets, this does not necessarily diversify risk. To properly diversify a portfolio, it is important to separate capital allocation from risk allocation – they are not the same thing.

Most commonly, investors believe that diversifying assets across traditional fixed income, equities and non-traditional assets is a smart thing to do. While going beyond geographic diversification makes sense, investors should now realize that the addition of non-traditional "alternatives" are an important consideration when trying to protect a portfolio and prosper over the long term. 

Chart 1 – Capital and Risk Allocation of a Typical Portfolio

So what’s the problem?

Balanced asset allocation, even with a healthy mix of traditional and alternative assets, does not necessarily mean that a portfolio’s risk is diversified. Investors often make a concentrated bet on equity performance even though they have both types of assets due to their generally high correlation to the stock market. Essentially, as referenced in Chart 1, the diversification of assets could still have a significant concentration of equity risk.  

 Just look at this pension fund (see Chart 2). Despite seemingly being responsible and diversifying its assets, the returns it receives from its investments have a very high correlation to the stock market. The pension has lost and made money at the same time as the S&P with a correlation of 0.85 despite having a diversity of capital allocation.

 Chart 2

So why does this happen?  

The reality is, most investments, including stocks, bonds and even alternatives have a high correlation to the stock market. This includes the most common areas of alternatives such as Real Estate, Private Equity and Infrastructure, which have some of the highest correlations to the market. Other common alternatives like High Yield, Hedge Funds, and Equity Multi-Strategy, which typically have been the first stops outside of the "traditional alternatives,” also suffer from this problem.   

Chart 3

Of the alternatives listed in the chart above, only Currency, Commodity, Agriculture and CTA/Managed Futures alternatives have a low-to-negative correlation to the market. While many investors have heard of these asset classes, investing in them may seem opaque and complicated. However, there are a number of institutional offerings for each of these areas that can be taken advantage of, and recently, more and more choices are becoming available to even the retail investor and advisor. The one caveat to this is, in certain markets like Canada, these areas are definitely underdeveloped and used by only the most sophisticated investors, which in our view, is extremely unfortunate.    

Arguably, the most important alternatives of all are the ones with a slightly negative correlation to equities because alternatives are largely intended to shield investors and diversify risk. This is commonly understood to be only available within the Managed Futures space. So what is it about this return stream that adds value to a portfolio yet has a negatively correlated return?

The answer lies in the fact that risk taking strategies can be broken down simply into two types – convergent and divergent. 

 Convergent return streams are most common, producing a return stream that is characterized by many small gains with an occasional devastating loss, as markets grind higher slowly for long periods of time with the risk of a sharp correction. This type of return stream is a “human” feel good strategy, as it gives investors constant gratification, often through yield or dividends, follows logical sense and is based in fundamentals. Whether classified as an alternative or not, the returns experienced under this stream will look a lot like that of an equity market and encompass both active and passive investment strategies. The reality is, most alternatives are this way, and as such, they do little to help your portfolio in difficult times as you get more of the same type of return stream.

In contrast, divergent return streams are less common yet are very valuable as they produce returns differently and at different times when compared to most investments. They are characterized by many small losses followed by an occasional large gain, often at times of crisis or correction. Unfortunately, they are not "feel good" strategies. In fact, to many, they feel like taking many small paper cuts, waiting patiently if possible for gains. These strategies go against the human need for constant gratification and are typically not based on fundamentals in order to produce an atypical return stream.  They are most often based on a repeatable process that is systematic, with fundamentals and no biases, ultimately producing returns that are generally derived from trend following. The most common strategies under this umbrella are Managed Futures/CTA investments.

As one can see, the real solution to creating a better portfolio, for any investor, is adding divergent alternative return streams that have a negative or near-zero equity correlation but still produce positive returns over time.

A better portfolio should be judged from a risk perspective, not just a capital allocation view.  To reduce portfolio risk while potentially increasing the opportunity or reward, the return stream should be accretive to what you may already have. From this perspective, there is no sense in adding more equity risk, as you’ll always land on the same problems when the markets correct

Want to see how correlated your portfolio is to the equity market? It is not overly complicated, all you have to do is run a correlation between your portfolio’s returns and the stock market, then look at the correlation of the components that make up your portfolio. Do you have any that are of low correlation to the equity market?  Hopefully you do. Perhaps you hold a commodity fund, agricultural play, or currency strategy. However, for most retail and institutional investors, this area is often overlooked despite their clear advantages. All you have to do is look at the chart below which illustrates the advantages of adding an investable CTA Index like the Auspice Managed Futures Excess Return Index (AMFERI) to a diverse portfolio of traditional and alternative asserts. The improvement is obvious, with not only better returns, but better risk-adjusted returns with a higher Sharpe ratio and lower volatility and drawdowns. 

The good news is these strategies are now available to both institutional and retail investors through not only private hedge fund structures, but mutual funds and low cost ETFs. 

It is only with these types of additions that one can diversify risk and really take advantage of the unknown while still having the opportunity for gains if the seemingly unflappable equity market keeps rallying – or just as likely – fails and reverses