Why investment funds may be toxic to your investment portfolio.
There are a number of misconceptions around diversification. But head and shoulders the number one misconception is so widespread, harmful and misunderstood.
First, the also rans.
- Diversification is De-worse-ification
Wrong. Diversification can only lower returns when you put in worse performing assets. Don’t blame diversification that all your investments are not as good as your best investment and don’t invest in (especially buy and hold) bad investment simply for diversification.
- Diversification does not work when you need it most
This one is tricky. Yes diversification will begin to fail during systematic (liquidity) crisis. Here we are talking generational black swan events. So yes, it might fail in the worst ones but it will help in the other 5 lesser crises.
- Diversification will save me. See # 2. Some people think too much of diversification, some people think too little of it. We have found that diversification actual works its mojo best during choppy or sideways markets, not during steeper declines.
OK. With those lesser misconceptions out of the way. What is the # 1 biggest misconception about Diversification?
Sadly, the number one misconception about diversification, is a by-product of those ignorant or deceitful marketing practices of the investment fund industry.
It is kind of like the food pyramid from the 70’s and 80’s. Before being replaced by My Plate, the food pyramid facilitated dangerous advice on nutrition worsening the Obesity crisis over the last 50 years. Your portfolio needs funds in it about as much as healthy humans need to base their diets on agricultural grains.
The misconception in a nutshell: funds are detrimental to diversification, not beneficial to it.It almost doesn’t matter what the fund is. Funds promote diversification, even if they should not deserve to. Any fund can promote its incredible diversification, with total impunity even if the statement is false. There is no one there to hold them accountable. The Securities and Exchange Commission or other Regulators simply just haven’t had the tools to sort out claims of diversification. They don’t know the difference. I invented Diversification measurement, and admittedly have not done a good job getting the word out. Please see https://portfoliothinktank.com/wp-content/uploads/2021/02/dimensions-of-diversification.pdf Diversification always breaks down to two parts, idiosyncratic diversification and systematic diversification. Idiosyncratic diversification is easy to achieve. Investors get idiosyncratic diversification by owning more positions. It doesn’t matter what the positions are; owning more positions increases idiosyncratic diversification. Funds do a great job of providing idiosyncratic diversification. They own lots of stuff. Investing in a fund for owning lots of stuff is like dating someone because they have lots of hair. It’s not a big accomplishment. Systematic diversification is about the interrelationships. Usually we think of this as the correlations amongst the Investments. Systematic diversification is harder to achieve. Scratch that: systematic diversification is hard to achieve. Systematic diversification becomes increasingly harder to achieve as the quantity of Investments increases. This is because every additional investment has to lower the average intra-portfolio correlation, within the correlation matrix. So why do funds worsen diversification? Funds basically trade systematic diversification for idiosyncratic diversification. In other words they give up the hard thing to get the easy thing. That’s like trading in your workout for a candy bar. Not exactly the path of the hero. Systematic diversification and idiosyncratic diversification count equally. Optimal portfolio diversification resides in finding the balance. This usually means investing in fewer Investments that are less correlated to one another. Here is the Correlation Matrix of 10 of the biggest Equity Funds.
Why it all matters.
Here is how this failure to diversify unravels the portfolio. When there’s no difference between assets there’s no utility to rebalancing. Rebalancing needs non-correlation to be effective. Missing out on rebalancing can cause investors perhaps 1% in lost returns a year in conventional portfolios.
What’s worse is that you are paying these fund managers to worsen your diversification and ruin your rebalancing bonus?!!?
More importantly still is the relationship between diversification and capital loss. In research I did with Houyan Sun of the University of Denver after the 2008 crisis, we discovered that every extra percentage point of diversification protected 98 basis points of capital throughout the crisis. This was sampled over about one hundred real world portfolios. We also demonstrated that the increased diversification didn’t cause any investors any upside. That is the essence of diversification as a free lunch.
Diversification is sort of a weakest link problem. Improvements to the weakest link stand to convey the greatest benefits.
Therefore, almost invariably, amongst fund managers, and without even knowing it because the industry is still blissfully ignorant on diversification, what they naively promote as diversification will cost investors all of the benefits hoped.
Any of the rebalancing and reallocation (re-optimization) benefits of diversification inure to the controller of the portfolio. This means that investors in the funds get some of the benefit of the funds internal diversification in the form of a smoother fund return and the diversification return achieved in the fund and inured to its investors. In an index fund or other passive strategy, there is no diversification return. (because this requires re-optimization or rebalancing). However, this is likely much less of a diversification return an investor can get if they rebalanced on their own or used Portfolio Thinktank’s re-optimization engine. But since you do not control the fund, you do not dictate when and how it is rebalanced so you only get some of the diversification benefit, not the actual diversification. Most funds are rather capricious about rebalancing and never re-optimize so their diversification alpha yield falls way short of what you can achieve by yourself.
100% of the diversification you do not get is the diversification lost in assembling your own portfolio. If you are assembling a portfolio of funds and you are suffering from the high correlations caused by averaging out all the idiosyncratic performance then you get no diversification and a small fraction of the total diversification benefit that you could have achieved.
For a better understanding on the potential benefit of diversification please see this snippet:
“Crucially, the Diversification Weighted 500 produced 652 bps of alpha per year on average for more than 18 years. The alpha for the five-factor model is 414 bps.”
I think it is reasonable to believe that the preponderance of the 4.14% of incremental returns every year is a function of fully exploiting the power of diversification.
Taken from our research Published in the Journal of Indicies are recreated on our website here.
Of course, this portfolio held too many assets, so it would be easy to improve upon, at least from a diversification return / diversification alpha perspective. If you are interested in the strategies to harvest diversification alpha, subscribe to portfoliothink on YouTube, as I will be posted how to and strategy links for those.
So if you are the client of a Financial Advisor and you have a version of one of their model portfolios and the model portfolio is investing in other funds now you have 4 problems:
- Paying the advisor
- Additional fund expenses
- Lack of control
- Lack of diversification
These cumulatively provide that the strategy will be probably underachieving its potential by several percentage points every year. For more details on the problems with model portfolios, please see https://portfoliothinktank.com/model-portfolio/
The bottom line is that you can’t trust the industry to get you diversification. You can’t trust the industry to make diversification work for you. You can measure your portfolio diversification when you put in your portfolio at www.PortfolioThinkTank.com. And you can wire it in to your strategy if you let us optimize it for you. See for yourself.
James’ professional orientation points at the zenith (and sometimes nadir) where technology and investments intersect. He is a Fintech entrepreneur and has served twenty years of a lifetime sentence.
James is a patented inventor, quant pioneer and investment manager. He is the founder of Gravity Investments, a unique investment and technology services firm centered on James’ inventions for diversification measurement, optimization, visualization, and analysis. In the development of the platform, James has pioneered A.I applications, diversification attribution, down-side diversification, portfolio re-optimization, full-lifecycle strategy optimization, programmable investment policy statements and core-satellite optimization techniques.
In working with advisors, funds and money managers as both a strategic sub-advisor and software consultant, James has consulted and trained hundreds of professional investors on portfolio design and optimization. James has a unique ability to look at any investment process and find practical, intelligent and often quantifiable opportunities to improve the investment product.
Inspired by the work of Nobel Laureate Harry Markowitz and the efficient frontier, James has championed and pioneered the science of diversification. James’ technology has advised
or assisted in over 30 Billion dollars of investor capital. His vision of a more perfect investment management system is at the heart of Gsphere ( www.gsphere.net )
His passion for performance, curiosity for the unknown, and drive to excel empower his service to investors.
James is Founder and CEO of Portfolio ThinkTank (the B2C company) www.portfoliothinktank.com, Founder & Chief of Financial Engineering at Gravity Investments www.gravityinvestments.com (the B2B company) and Chief Investment Officer at Gravity Capital Partners, a wholly owned SEC Registered Investment Advisor.