Advancements in technology and new knowledge have made it easier to diversify portfolios and manage investment management fees. Greater clarity over sources of returns have placed downward pressure on active manager’s fees. True sources of portfolio diversification can command a higher fee and are worth considering.
Is your portfolio managed as if it is the 1980s? the 1990s? Does it include any of the key learnings from the Tech Bubble crash of 2000 and the market meltdown of the Global Financial Crisis (GFC or Great Recession)?
Finally, is your portfolio positioned for future trends in portfolio management?
Below I provide a short history of the evolution of portfolio diversification. The evolution of portfolio diversification is interesting and can be referenced to determine how advanced your portfolio is.
The framework, idea, and some of the material comes from a very well written article by Aberdeen Standard Investments (ASI).
Unless stated otherwise, the opinions and comments below are mine.
Standing on the Shoulders of Giants
Nobel Laureate and pioneer of investment theory Harry Markowitz’s 1952 paper “Portfolio Selection” provided the foundations for Modern Portfolio Theory (MPT).
Markowitz’s analysis provided the mathematical underpinnings for portfolio optimisation.
The key contribution of Markowitz was the quantification of portfolio “risk”. Portfolio Risk was measured by the variation in investment returns – standard deviation of returns.
Markowitz’s paper led to the concept of an “optimal portfolio”, a framework in which both risk and returns are considered. Optimal portfolios offer the maximum expected return for a defined level of risk.
The benefits of diversification were clear to see. Diversification reduces risk without sacrificing returns.
As the ASI article noted: Markowitz called diversification “the only free lunch in finance”.
MPT led to the establishment of the 60:40 portfolio, a portfolio of 60% equities and 40% fixed income.
Increased Diversification of the 60:40 Portfolio
The 60:40 portfolio dominated for a long period time. This portfolio was also largely domestically orientated i.e. the concept of investing internationally was not widely practiced in the 1960 – 70s, even early 1980s.
The next phase in portfolio diversification largely focused on increasing the level of diversification within the equity and fixed income components of 60:40 Portfolio.
As outlined in the ASI paper, four trends combined to drive a broadening of investments in 1980s and 90s:
- deregulation of financial markets
- rapid growth in emerging markets
- financial innovation
- academic ‘discoveries’.
Deregulation played a major role, particularly the ending of fixed currency exchange rates and the relaxing of capital controls. This enabled an increased level of investing internationally.
This also coincided with the discovery of the “emerging markets”, leading to an increased allocation to emerging market equities and fixed income securities.
Financial innovation resulted in the development of several new financial instruments, including mortgage-backed securities, high-yield bonds (formally called Junk Bonds), and leverage loans.
The use of derivatives also grew rapidly following the establishment of Option Pricing Theory.
Other academic discoveries led to style investing, such as value and growth, and the rise of investing into smaller companies to add value and increase diversification. Style investing has been superseded by factor investing, which is discussed further below.
ASI conclude, that at the end 1990’s portfolio diversification could be characterised as including:
- domestic and international equities
- value and growth stocks
- large-cap and small-cap stocks
- developed and emerging markets
- government, mortgage and corporate fixed income securities.
Fundamentally, this is still a portfolio of equities and bonds. Nevertheless, compared to the domestic two-asset class 60:40 Portfolio of the 1960 – 70s it offered more diversification and weathered the severe market declines of tech bubble burst in 2000 and GFC better.
Pioneering Portfolio Management – the Yale Endowment Model
The 2000’s witnessed the emergence of the “Endowment Model”. This followed a period of strong performance and evidence of their diversification benefits during the tech bubble burst of 1999-2000.
The Endowment model has been characterised as being based on four core principles: equity bias, diversification, use of less-liquid or complex assets, and value-based investing.
Endowments allocate the largest percentages of their portfolios to alternative asset classes like hedge funds, private equity, venture capital, and real assets e.g. property.
The endowment model was pioneered by David Swensen at Yale University. Yale’s alternative assets fell into three categories: absolute return (or hedge funds); real assets (or property and natural resources); and private equity.
For more on diversification approach adopted by Endowments and Sovereign Wealth Funds please see my previous Post Investment Fees and Investing like and Endowment – Part 2.
Learnings from Norway
The extreme severity the GFC tested all portfolios, including the Endowment Model.
The dislocation in markets muted the benefits of diversification from alternative investments and left many questioning the actual level of diversification within their portfolio.
In 2009 this disappointment prompted the Norwegian Government Pension fund to commission a study to investigate their returns during the GFC.
The study was undertaken by three prominent professors, Andrew Ang (Columbia Business School), William Goetzmann (Yale University) and Stephen Schaefer (London Business School). The paper is well worth reading.
This study went on to influence portfolio diversification considerations and captures some major learnings from the GFC. The study brought factor investing into greater prominence.
Factors are the underlying drivers of investment returns. The Nordic study recommended that factor related returns should take centre stage in an investment process.
As a result, the Norwegians rethought about how they structured their portfolios. Other countries have followed, incorporating factor investing into their asset allocations.
Innovation and pressure on Investment Management Fees
The period since the GFC has yielded an increasing level of innovation. This innovation has been driven in part by factor investing, technology advancements, pressure on reducing investment management fees, and increased demand to access more liquid alternative investment strategies to further diversify portfolios.
The disaggregation of investment turns has provided a new lens in which to view portfolio diversification. With technology advancements and the rise of factor investing returns from within markets have been isolated. Broadly speaking, investment returns can be attributed to: market exposures (beta e.g. sharemarkets); underlying factors (e.g. value and momentum); hedge fund strategy returns (e.g. relative value and merger arbitrage); and returns purely attributable to manager skill (called alpha, what is left if the previous sources cannot explain all the return outcome). For a fuller discussion please see my earlier Post on Disaggregation of Investment Returns.
These trends have resulted in the proliferation of ETFs and the downward pressure on investment management fees. The active manager has been squeezed, with investors only wanting to pay fees relative to the source of return i.e. very very low fees for beta and higher fees for alpha.
These developments have also resulted in the rise of liquid alternatives. Returns once attributed to hedge funds can now be more easily accessed, from a cost and liquid perspective.
Increasingly these strategies are available in an Exchange Trade Fund (ETF) structure.
True Portfolio Diversification
Consequently, there is a now a greater ability to significantly diversify the portfolios of the 1980s and 1990s and take on the learnings from GFC and 2000 Tech bubble.
Increasingly Institutional investors accept that portfolio diversification does not come from investing in more and more asset classes. This has diminishing diversification benefits e.g. adding global listed property or listed liquid infrastructure to a multi-asset portfolio that includes global equities. True portfolio diversification is achieved by investing in different risk factors that drive the asset classes e.g. duration, economic growth, low volatility, value, and growth. Investors are compensated for being exposed to a range of different risks.
True diversification involves taking the learnings from the endowment model and the Norwegian Government Pension Fund study.
As a result, the inclusion of alternative investments is common place in many institutionally managed portfolios. For further discussion, see my previous Post on adding alternatives to a portfolio, it is an Evolution not a Revolution. This Post highlights that more asset classes does not equal more diversification may also be of interest.
Goal Based Investing and the extinction of the 60:40 Portfolio
Advancements in technology have helped investors understand the different dimensions of risk better and move away from the sole risk measure of MPT (standard deviation of returns).
Likewise, there has been a growing appreciation that failure to meet your investment objectives is the greatest investment risk.
More advanced portfolio construction approaches such as Liability Driven Investing (LDI) have been embraced.
Goal-Based Investing for the individual is based on the concepts of LDI.
The move toward Goal-Based Investing completely upturns portfolio construction, likely resulting in the extinction of the 60:40 Portfolio.
This paradigm shift within the industry is best captured by analysis undertaken by EDHEC Risk Institute. I covered the most relevant EDHEC article in more depth recently for those wanting more information. This Post outlines future trends in Wealth Management.
Future Direction of Diversification
The ASI article finishes by discussing several trends they believe are reshaping portfolio construction. Some of these trends have been discussed on Kiwiinvestorblog.
I would like to highlight the following trends identified by ASI:
- Investors continue to shift from traditional to alternative assets, see the recent Prequin Post.
- Investors are increasingly integrating environmental, social and governance (ESG) analysis into their decision-making process.
- Opportunities to invest in emerging markets are increasing.
- Individuals have to take more responsibility for their financial futures. This is known as the Financial Climate Change.
As ASI conclude “If done well, diversification can lead to improved long-term returns delivered in a smoother fashion.”
I would also add, and it is worth reflecting upon, although the benefits of diversification are without question, Modern Portfolio Theory of the 1950s can hardly be considered modern.
Please see my Disclosure Statement