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The realities of diversification

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The views expressed in these posts are those of the authors and are current only through the date stated. These views are subject to change at any time based upon market or other conditions, and Eaton Vance disclaims any responsibility to update such views. These views may not be relied upon as investment advice and, because investment decisions for Eaton Vance are based on many factors, may not be relied upon as an indication of trading intent on behalf of any Eaton Vance fund. The discussion herein is general in nature and is provided for informational purposes only. There is no guarantee as to its accuracy or completeness. Past performance is no guarantee of future results.

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      By Richard Bernstein, CEO and CIO, Richard Bernstein Advisors LLC

      New York - Insurance policies always carry a premium that must be paid to the insurer by the insured in exchange for protection against an adverse event. It would be nice to receive a huge payout for free when something unfortunate happens, but that isn't reality. Most of us understand that concept well, but investors too often lose sight of that simple concept when it comes to portfolio management.

      Investors forget that portfolio diversification is an insurance policy against one's view of the world being incorrect. Like all insurance policies, diversification comes with a premium that must be paid. However, investors seem to believe that portfolio diversification is available without an insurance premium. People realize the fantasy of an insurance policy that comes with no premium, but somehow investors remain captivated by the idea that portfolios can be diversified without hindering performance.

      At RBA, we try to invest in negatively correlated asset classes rather than uncorrelated asset classes. Whereas uncorrelated asset classes (other than cash) sometimes lose their diversification properties during bear markets, that more rarely happens to negatively correlated asset classes. However, because negatively correlated asset classes generally underperform during an equity bull market, investing in negatively correlated asset classes can be a drag on performance. That drag on performance is the insurance policy premium.

      What if there were no risk?

      If one knew with 100% certainty that there was going to be a bull market over the next 12 months, then one would likely be 100% invested in equities. It might be prudent under those circumstances to invest in high-beta stocks or to borrow to be more than 100% in equities or both. Investors tend not to do those things because they cannot perfectly predict equity returns. However, "aggressive" portfolios tend to be less diversified, whereas "conservative" portfolios tend to be more diversified.

      Chart 1 compares the returns of the S&P Target Risk® Aggressive Index with those of the S&P Target Risk® Conservative Index. The more aggressive index currently has roughly 80% in stocks. The more conservative index accentuates asset classes such as bonds (roughly 70%). Chart 2 highlights the 12-month rolling volatility of each portfolio.

      Although the aggressive index outperforms the conservative index over the past 17 years, the aggressive index's volatility is considerably higher. Recently, the volatility of the aggressive index has been more than twice that of the conservative index (7.0% vs. 3.1%). The performance of these two indexes reinforces the idea that there is no "free lunch." In other words, higher returns necessarily come with more risk, and the insurance against higher volatility and portfolio losses comes with a premium that must be paid called lower returns.

      Blog Image RBA Figure 1 Oct 31

      Source: Bloomberg Finance L.P. For Index descriptors, see "Index Descriptions" at end of post.

      Blog Image RBA Figure 2 Oct 31

      Source: Bloomberg Finance L.P.

      Diversification and lowering volatility

      RBA aims to lower the volatility of our portfolios and enhance upside/downside results by investing in negatively correlated asset classes. Chart 3 shows asset class correlations and betas to the S&P 500®. There are several important conclusions from this chart:

      1. Some asset classes commonly referred to as uncorrelated, such as hedge funds, are quite correlated. Although their betas are low, meaning they tend to move in smaller increments than the overall equity market does, they do seem to move in tandem with the equity market.

      2. Diversification is not simply a function of whether an asset class is called "stocks" or "bonds" or "U.S." or "non-U.S." Note that correlations to the S&P 500® tend to increase as assets' underlying exposures to the business cycle increases. U.S. high yield and Treasurys are both typically categorized as "bonds," but this analysis suggests their diversification potential is starkly different. See our report from several years ago on this topic.

      3. Cash is indeed an uncorrelated asset class (beta roughly 0.0 and correlation roughly 0%). Chart 4 shows the returns of cash versus stocks. The insurance premium associated with investing in cash instead of stocks over the past 20 years (which includes two meaningful bear markets) has been almost 600 basis points/year. That difference in returns indicates it's VERY expensive to attempt to insure against virtually all risk.

      Blog Image RBA Figure 3 Oct 31

      Sources: Richard Bernstein Advisors LLC., Standard & Poor's, HFRI, MSCI, Bloomberg Finance L.P.

      Blog Image RBA Figure 4 Oct 31

      Source: Bloomberg Finance L.P.

      There's no free lunch!

      All insurance has a cost associated with it, and so does diversification because it helps protect against adverse events hurting wealth. The notion that one can effectively diversify a portfolio without paying an insurance premium of giving up some return sounds enticing, but ultimately seems erroneous.

      At RBA, we try to diversify our portfolios and, although we comparison shop for "policies," we do pay the insurance premium.