The best way to manage periods of severe sharemarket declines, as recently experienced, is to have a diversified portfolio, it is impossible to time these episodes.
A 2018 paper by AQR evaluated the effectiveness of diversifying investments during sharemarket drawdowns using nearly 100 years of market data.
They analysed the potential benefits and costs of shifting away from equities, including into investments that are diversifying (i.e. are lowly correlated to equities) and investments that provide a market hedge (i.e. expected to outperform in bad times).
To diversify a portfolio AQR recommends adding return sources that make money on average and have a low correlation to equities i.e. their returns are largely independent of the performance of sharemarkets.
They argue that diversification should be true both in normal times and when most needed: during tough periods for equities.
Furthermore, as AQR emphasis, “diversification is not the same thing as a hedge.” Although “hedges”, e.g. Gold, may make money at times of sharemarket crashes, there is a cost, investments with better hedging characteristics tend to do worse on average over the longer term.
Therefore, alternative investments are more compelling relative to the traditional asset classes in diversifying a portfolio, they provide the benefits of diversification and on average over time their returns tend to keep up with sharemarket returns.
The analysis highlights that the funding source can matter just as much as the new diversifying investment. Funding from equities reduces drawdown losses, however, longer term returns are on average lower when compared to funding the allocation proportionally from the 60/40 equity/fixed income split.
Portfolio diversification is harder to achieve in practice than in theory. It involves adding new “risks” to a portfolio. Risks that have their own return profile largely independent of other investment strategies within a Portfolio.
Unfortunately, portfolio diversification does not eliminate the risk of experiencing investment losses.
Any new lowly correlated investment should be vigorously assessed and well understood before added to a portfolio.
The success of which largely rests with manager selection.
A summary of the AQR analysis is provided below, first, the following section discusses the challenges and characteristics of achieving portfolio diversification.
The challenges and characteristics of Portfolio Diversification
AQR advocate that diversification is a better solution to mitigating the pain of severe sharemarket falls than trying to time markets.
Specifically, they recommend adding return sources that make money on average and have a low correlation to equities.
Lowly correlated assets can be tremendously valuable additions to a portfolio.
Lowly correlated means returns that are not influenced by the other risks in the portfolio e.g. hedge funds and liquid alternative strategy returns are largely driven by factors other than sharemarket and fixed income returns.
Therefore, although diversifying strategies can lose money in large sharemarket drawdowns, this does not mean they are not portfolio diversifiers. The point being, is that on “average” they do not suffer when equities do.
Unfortunately, portfolio diversification does not eliminate the risk of experiencing investment losses.
In contrast, a hedge is something you would expect to do better than average exactly when other parts of the portfolio are suffering. Although this sounds attractive, hedges come with a cost. This is discussed further below.
Adding diversifying strategies to any portfolio means adding new risks.
The diversifying strategies will have their own risk and return profile and will suffer periods of underperformance – like any investment.
Therefore, as AQR note, implementing and maintaining portfolio diversification is harder in practice than in theory.
Portfolio diversification in effect results in adding new risks to a portfolio to make it less risky. Somewhat of a paradox.
This can be challenging for some to implement, particularly if they only view the risk of an investment in isolation and not the benefits it brings to the total portfolio.
Furthermore, adding more asset classes does not equal more diversification, as outlined in this Post.
Most portfolios are dominated by sharemarket risk. Even a seemingly diversified balanced portfolio of 60% equities and 40% fixed income is dominated by equity risk, since equities tend to be a much higher-risk asset class. Although equities have had high average returns historically, they are subject to major drawdowns such that the overall “balanced” portfolio will suffer too. The Balance Portfolio is riskier than many appreciated, as outlined in this Post.
A major sharemarket drawdown is characterised as a cumulative fall in value of 20% or more. Recent examples include the first quarter of 2020, the Global Financial Crisis (2008/09) and Tech Bust (1999/2000). Based on the AQR analysis of almost 100 year of data, drawdowns worse than 20% have happened 11 times since 1926 — a little over once per decade on average. The average peak-to-trough has been -33%, and on average it took 27 months to get back to pre-drawdown levels (assuming investors stayed invested throughout – there is considerable research that indicates they don’t stay the course and earn less than market returns over the investment cycle).
AQR’s analysis highlights that using market valuations as a signal to time market drawdowns has not always been fruitful. Market valuations has rarely been a good signal to tactically change a portfolio to avoid a market drawdowns.
However, it is worth noting AQR are not against the concept of small tactical tilts within portfolios based on value or other signals such as momentum, best expressed as “if market timing is a sin, we have advocated to “sin a little””.
Nevertheless, market timing is not a “panacea” for large sharemarket drawdowns.
The AQR analysis highlights that diversification outside of equities and fixed income can benefit portfolios, for example the inclusion of Style strategies (long/short risk premium across several different asset classes) and Trend following. Both of which are found to be lowly correlated to equities and provide comparable returns over market cycles.
Interestingly, the benefits of diversification vary from where the source of funds is taken to invest into the diversifying strategies.
AQR look at the impact on the portfolio of making an allocation from a 60/40 portfolio to the diversifying strategies. They consider two approaches:
- Funding the allocation all equities; and
- Funding from a combination of equities and fixed income, at a 60/40 ratio.
They evaluate a 10% allocation from the funding source to the new investments and consider both the impact on returns during equity drawdowns as well as the impact on returns on average over the entire 1926–2017 period.
The analysis highlights that the funding source can matter just as much as the new diversifying investment.
Funding from equities reduces the drawdown losses, however there is a trade-off, longer term returns are on average lower when compared to funding the allocation proportionally to the 60/40 equity / fixed income split.
When allocating to other traditional asset classes as a means of diversification e.g. Cash and Fixed Income, there is also a trade-off between a lower portfolio drawdown and lower average returns over time.
Therefore, alternatives offer a more compelling case relative to the traditional asset classes in diversifying a portfolio, given they provide the benefits of diversification and on average over time their returns tend to keep up with sharemarket returns.
The Cost of Hedging
As noted above Hedging is different to adding diversifying strategies to a portfolio.
Hedges may include assets such as Gold, defensive strategies – which hedge against market falls, and Put Option strategies.
The AQR analysis found that over the past 30 years the defensive strategies provided positive returns on average during sharemarket drawdowns and almost no periods with meaningful negative performance.
This is attractive for investors who are purely focused on lessening the negative impacts of sharemarket drawdowns.
However, there is a trade-off – “the strategies that are more defensively orientated tend to have lower average returns.”
The cost of avoiding the sharemarket drawdown is lower portfolio performance over time.
AQR conclude “As with everything in investing, there is no perfect solution to addressing the risk of large equity market drawdowns. However, we find using nearly a century of data that diversification is probably (still) investors’ best bet. This is not to say that diversification is easy.”
“Investors should analyze the return and correlation profiles of their diversifying investments to prepare themselves for the range of outcomes that they should expect during drawdowns and also over the long term.”
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