What does a diversified portfolio look like?
This is answered by comparing a number of portfolios, as presented below.
Increasingly Institutional investors accept that portfolio diversification does not come from investing in more and more asset classes. This has diminishing diversification benefits. Investors are compensated for being exposed to a range of different risks.
True portfolio diversification is achieved by investing in different risk factors that drive the asset classes e.g. duration, economic growth, low volatility, value, illiquidity, and growth.
As a result, the inclusion of alternative investments is common place in many institutionally managed portfolios.
This Post draws heavily on a number of sources, including a very good article by Willis Tower Watson (WTW), Lets get the balance right.
The WTW article is extensive and covers a number of issues, of interest for this Post is a comparison between WTW Model portfolio and 30%/70% low cost Reference Portfolio (30% Cash and Fixed Income and 70% Equities).
To these portfolios I have compared a typical diversified portfolio recommended by US Advisors, sourced from the following Research Affiliates research paper.
Lastly, I have compared these portfolios to the broad asset allocations of the KiwiSaver universe. Unfortunately I don’t have what a typical New Zealand Advisor portfolio looks like.
I have placed the data into the following Table for comparison, where Domestic reflects Australia and US respectively.
|WTW Model||Reference Portfolio||Typical US Advisor|
|Domestic Fixed Interest||13.0%||15.0%||28.0%|
|Global Fixed Interest||15.0%|
|US High Yield||4.0%|
|Commodities / Real Estate||4.0%|
|Emerging Markets Bonds||1.0%|
|Broad Asset Classes|
|Cash and Fixed Income||15.0%||30.0%||28.0%|
Non Traditional are portfolio allocations outside of cash, listed equities, and fixed income e.g. Private Equity, Hedge Funds, unlisted investments, alternative beta
The Table below comes from a previous Kiwi Investor Blog, KiwiSaver Investors are missing out, comparing Australian Pension Funds, which manage A$2.9 trillion and invest 22.0% into non-traditional assets, and KiwiSaver Funds which have 1% invested outside of the traditional assets. Data is sourced from Bloomberg and Stuff respectively.
|Allocations to broad asset classes||KiwiSaver||Aussie Pension Funds|
|Cash and Fixed Interest (bonds)||49||31|
|Other / non-traditional assets||1||22|
From my own experience, I would anticipate that a large number of Australian Pension Funds would have a larger allocation to unlisted infrastructure and direct property than outlined above.
If a picture tells a thousand words, the Tables above speak volumes.
The focus of this blog is on diversification, from this perspective we can compare the portfolios as to the different sources of risk and return.
It is pretty obvious that the Reference Portfolio and KiwiSaver Funds have a narrow source of diversification and are heavily reliant on traditional asset classes to drive performance outcome. Somewhat concerning when US and NZ equities are at historical highs and global interest rates at historical lows (the lowest in 5,000 years on some measures).
Furthermore, as reported by the Bloomberg article, the allocations to non-traditional assets is set to continue in Australia ”with stocks and bonds moving higher together, investors are searching for other areas to diversify their investments to hedge against the fragile global economic outlook. For the world’s fourth largest pension pot, that could mean more flows into alternatives — away from the almost 80% that currently sits in equities, bonds or cash.”
Globally allocations to alternatives are set to grow, as outlined in this Post.
The WTW Model portfolio has less of a reliance on listed equity markets to drive investment returns, maintaining a 49% allocation relative to the Reference Portfolio’s 70%.
Therefore, the Model Portfolio has a broader source of return drivers, 36% allocated to non-traditional investments. As outlined below this has resulted in a similar return over the longer term relative to the Reference Portfolio with lower levels of volatility (risk).
Concerns of current market conditions aside, a heavy reliance on listed equities has a number of issues, not the least a higher level of portfolio volatility.
The Reference Portfolio and the KiwiSaver portfolios have a high allocation to equity risk. In a portfolio with a 65% allocation to equities, over 90% of the Portfolio’s total risk can be attributed to equities.
Maintaining a high equity allocation offers the prospect of higher returns, it also comes with higher volatility, and a greater chance for disappointment, as there is a wider range of future outcomes.
Although investors can experience strong performance, they can also experience very weak performance.
Comparison Return Analysis
Analysis by WTW highlights a wide variation in likely return outcomes from a high listed equity allocation.
By using 10 year performance periods of the Reference Portfolio above, since 1990, returns over a 10 year period varied from +6.4% p.a. above cash to -1.5% p.a below cash.
It is also worth noting that the 10 year return to June 2019 was the Cash +6.4% p.a. return. The last 10 years has been a very strong period of performance. The median return over all 10 year periods was Cash +2.6% p.a.
The returns outcomes of WTW Model are narrower. Over the same performance periods, 10 year return relative to Cash range from +6.2% and +0.2%.
Over the entire period, since 1990, the Model portfolio has outperformed by approximately 50bps, with a volatility of 6% p.a. versus 8% p.a. for the Reference Portfolio, with significantly lower losses when the tech bubble burst in 2002 and during the GFC. The worst 12 month return for the Reference Portfolio was -27% during the GFC, whilst the Model Portfolio’s loss was 22%
A high equity allocation is detrimental to a portfolio that has regular cashflows i.e. Endowments, Charities, and Foundations. They need to seek a broad universe of return streams. This was covered in a previous Post, Could Buffet be wrong?
Likewise, those near or in the early stages of retirement are at risk from increased market volatility and sequencing risk, this is cover in an earlier Post, The Retirement Planning Death Zone.
For those wanting a short history of the evolution of Portfolio Diversifications and the key learnings over time, this Post may be of interest.
Let’s hope we learn from the Australian experience, where there has been a drive toward lowering costs. There is a cost to diversification, the benefits of which accrue over time.
As WTW emphasises, let’s not let recent market performance drive investment policy. The last 10 years have witnessed exceptional market returns, from which the benefits of true portfolio diversification have not been visible, nor come into play, and the low cost investment strategy has benefited. The next 10 years may well be different.
In summary, as highlighted in a previous Post, KiwiSaver Investors are missing out, their portfolios could be a lot more robust and better diversified. The risks within their portfolios could be reduced without jeopardising their long-term investment objectives, as highlighted by the WTW analysis.
Please see my Disclosure Statement
Global Investment Ideas from New Zealand. Building more Robust Investment Portfolios.