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Beware the Lure of Diversification

To truly diversify a traditional portfolio, alternative investments need to be cheap and behave differently than stocks and bonds.

Michael Coop, 06/17/2013

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 total portfolio outcomes if it suffers a large fall in value, as tends to happen after surges in popularity and prices.

Michael Coop is head of alternative investments for Ibbotson Associates Australia.
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