A Prime Opportunity To Improve Diversification
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2022 was a difficult year for most investors and advisors. The one silver lining is that this year end provides one of the best opportunities in more than a decade to improve diversification using funds raised from tax loss harvesting. Making the most of it requires looking outside of typical stocks, bonds and credit to other assets like commodities and gold. Increasing good alpha exposures can also increase portfolio diversification and agility to navigate through this challenging market environment. There are lots of different good options and now is a uniquely good time to allocate to them.
The best way to get a sense of the benefit of diversification is to look at the improvement in portfolio risk/return for an incremental allocation to a given asset. The chart below shows the impact of allocating 10% of a currently 60/40 portfolio to a range of betas and alphas (using hedge fund index strategy returns at an assumed 1% fee). To make it simple, pretty much any assets or strategies other than stocks and bonds are a pretty good diversification step.
There is no precise way to measure diversification benefit, but what we tried to do was give a large enough sample size to get a good mix of environments to understand how the assets would complement 60/40. Estimates for beta start in 1970 and are assumed to be costless. Estimates for the alpha strategies start in 2002 (when widespread hedge fund performance coverage begins) and are assumed to have a 1% management fee. Incremental diversification was measured using the % change in the Sharpe ratio from a 10% allocation away from 60/40 to the given asset or strategy.
Figuring out how exactly to allocate between these possible options is by no means a mechanical exercise. It’s important to compare the future reliability of diversification benefit shown above and an investors ability to gain access to the strategy. Betas (like gold and commodities) are cheap to implement (ETFs like $BCI or $IAU) and the pattern of returns is very reliable.
Alpha strategies are harder to find and implement. Just because the return of a diversified set of managers in any given strategy is good doesn’t mean that any one manager of that style will be as good over time. Further, individual managers may be far more expensive than what's shown above and in tax inefficient structures, which eats into returns. Therefore, because of lower reliability, alpha as a diversification tool should be used less than beta options.
To get a sense of the possible improvement in returns, we compare a typical 60/40 portfolio to one where 30% of the 60/40 is allocated equally to gold, broad commodities, and diversified alpha strategies. That incrementally diversified portfolio has performed better on nearly all performance metrics over the last 20+ years including return, volatility, shape ratio, line ratio, drawdowns, and compound cumulative returns. And it has done so without creating a lot of tracking risk relative to the traditional 60/40.
If anything, this probably understates the benefit of increased diversification on a forward-looking basis. The allocation differences above are essentially tested across a secular environment of low and stable inflation and easy money where bonds were a uniquely good diversifier to stock market exposures. Today’s macroeconomic environment is much different - a more typical inflationary tightening cycle with secular pressures shifting from disinflation to inflation. In that dynamic, assets like commodities and gold offer a uniquely beneficial diversification opportunity and alpha managers have more opportunity to shine. That creates all the more urgency to use this opportunity to increase portfolio diversification.