YUP, Diversification Still Works
Did you read our 2015 Annual Letter, entitled “Navigating Active Asset Allocation When Diversification Fails?” If not, you should because some of the things that are happening in the markets right now are eerily in line with the topics addressed therein. To wit, the letter began:
In most years…even as a portfolio is struggling it is possible to point to a few investments that performed admirably. This reality reinforces for clients the purpose of diversification; portfolios ought to hold assets with diverse performance profiles to optimize risk-adjusted returns.
But sometimes there’s a dearth of positive items to highlight, and 2015 was one of those years. Last year, very few investors – especially the thoughtful, globally-diversified FAs we often speak with – were able to reap the benefits of diversification.
Following this relatively somber opening, we began an exploration of the myriad reasons global tactical asset allocators struggled through calendar 2015. We won’t go into full details here, because read the report, but we did identify multiple dynamics which normally contribute to the success of diversified strategies, but which all broke down simultaneously in 2015. Among them:
- Average returns from top assets were the lowest in at least two decades.
- The performance dispersion between asset classes was at historical lows.
- Asset classes frequently crossed above and below their zero-return boundary.
Concluding this discussion we offered up several reasons why – while constantly striving to improve – we remain committed to global diversification. We wrote:
It is natural to wonder whether the environment we experienced in 2015 will continue to confound global strategies like ours in 2016 and beyond. While we can offer no guarantee that the situation will improve, our confidence is bolstered by the knowledge that in markets, it is almost always darkest before the dawn. To be clear, we are agnostic as to which way the markets move, as long as they do so with sufficient magnitude, diversity, and clarity of signal…
…Over the short term, outcomes…are mostly dominated by luck. However, in the long-term investment success is a function of disciplined, diversified exposure to methodologies with solid economic merit, and a long-term track record of persistent returns.
No sooner had we published our Annual Letter, addressing head on the adversity of 2015 and the reasons to stay committed to a thoughtful and risk-managed process, than global equity markets started to tumble. However, our long-only diversified global mandates were, perhaps unsurprisingly, able to navigate the market turmoil with aplomb.
Figure 1. ReSolve USD Globally Diversified Mandates vs. Popular Benchmarks – Equity
Figure 2. ReSolve USD Globally Diversified Mandates vs. Popular Benchmarks: Returns and Maximum Drawdowns
For the record, we vehemently eschew any focus on short-term results. In fact, it is mostly impossible to distinguish investment skill from luck even when observing performance over many years. To ReSolve, a thoughtful investment process is a significantly better predictor of long-term success than a model’s short-term historical performance. Which is why it’s important to understand how this happened.
First off, note that we didn’t do anything differently in January 2016 than we did in 2015. We followed the same process, constantly seeking out diversified global portfolios with persistent positive momentum. But in contrast to most of 2015, the investment environment in January of 2016 presented an abundance of opportunity. First off, global markets offered differentiated assets with persistent momentum and materially positive performance that our process was able to capitalize on. Of course, those assets (government bonds) were not what investors typically – and myopically – focus on (stocks). But that’s why we’re agnostic about market direction; because in most environments we can count on the fact that there is a bull market somewhere, even during a bear market in stocks.
That said, while our portfolios were universally skewed toward positively trending Treasury bonds in January, our process did not eschew stocks entirely. That’s because of our focus on diversification. In fact, the following charts illustrate our average holdings on the month, and their average risk contributions in the portfolio. Note that, while portfolios were heavily skewed toward Treasuries, especially in terms of capital allocation, risk contributions were much more balanced. Figures 3. and 4. show that while on average the portfolio had about 80% of capital in Treasury bonds, risk was more evenly distributed, with stocks and REITs contributing almost 40% of portfolio risk (1.9% percentage points of volatility out of 5.3% total portfolio volatility).
Figure 3. ReSolve Adaptive Asset Allocation (8% Volatility Target, USD): Average Portfolio Holdings in January 2016
Figure 4. ReSolve Adaptive Asset Allocation (8% Volatility Target, USD): Average Risk Contributions in January 2016
Of course, another distinguishing feature of ReSolve mandates is that they were fully invested at all times during the month. In contrast, many global tactical strategies leaned heavily on concentrated cash positions to weather the market’s turbulence. Not only is this type of position evidence that a methodology is vulnerable to extreme bets, it is also a sign of a fragile approach that is particularly exposed to just one or two wrong-way positions. Furthermore, the purpose of investing is to gain exposure to risky assets to earn a long-term risk premium. This is largely defeated by a process that spends a meaningful amount of time in low-yielding cash.
In summary, January offered a rare opportunity to see which investment methods were ‘swimming naked’ as the proverbial tide went out for global equities. While no investment approach will deliver positive performance all the time, global strategies that actively promote diversification are more reliable than most.
To learn more about our spectrum of globally diversified strategies, please visit our Investment Solutions.