Harry Markowitz, Nobel Laureate and pioneer of investment theory, called diversification "the only free lunch in finance". It offers the prospect of reducing risk without sacrificing returns. The two major equity bear markets during the last two decades tested this theory. Traditional balanced portfolios suffered significant declines during the bursting of the dotcom bubble. Gains from government bonds were insufficient to offset equity losses. Investors responded by diversifying across a broader range of asset classes and strategies. Yet most multi-asset funds suffered similar declines during the global financial crisis.
The recovery from 2009 lows has provided a different challenge. Most diversified multi-asset portfolios have lagged equity markets since the last crisis.
Today, bond yields across the developed markets are extremely low. They offer little protection to investors if inflation picks up. Equity market valuations appear rich, leaving markets vulnerable when this elongated economic cycle ends. This increases the appeal of alternative asset classes, driven by different fundamentals. So what should investors expect from a diversified multi-asset portfolio? To help answer this question, we look at the successes and failures of multi-asset investing over sixty years. We examine how investment strategy has evolved since the 1952 publication of Markowitz’s landmark paper, Portfolio Selection.
We argue there have been three step-changes in diversification strategy: the first driven by globalisation; the next two triggered by the two major bear markets.
We look at best practice today. And we peer into the future.
The pre-history of diversification
Diversification is as old as finance. Cuneiform tablets discovered in modern Turkey capture the trading activities of merchants from Assur, an ancient Mesopotamian city-state. Around 4,000 years ago, these traders established sophisticated equity trading partnerships that extended over multiple years. These allowed investors to diversify their risks by funding more than one partnership.
The insurance industry dominated institutional investing from the early nineteenth century to the middle of the twentieth. Diversification of risk across the pool of policyholders provided the foundations for the industry. Interest rates fell steadily in the second half of the nineteenth century. Insurance companies switched from public to private credit markets in search of higher returns.
The First World War ushered in a new inflationary cycle. This brought the need for a different investment strategy. In 1924, economist and investor Edgar Lawrence Smith published Common Stocks as Long Term Investments. It highlighted the premium return offered by stocks. A few innovative investors started to invest in equities soon after.
Diversification 1.0: the 60:40 portfolio
The publication of Portfolio Selection by Harry Markowitz in 1952 ushered in the era of modern portfolio theory. Investors could now quantify portfolio risk. Analysis of risk stood shoulder to shoulder with analysis of expected returns.
Markowitz’s work provided the mathematical underpinnings for portfolio optimisation. It gave investors a tool to build portfolios on the ‘efficient frontier’ – offering the maximum expected return for a defined level of risk.
It also provided the starting point for Bill Sharpe’s work on the Capital Asset Pricing Model (1964). Sharpe addressed how investors would value assets if they religiously followed Markowitz’s recommendations. He introduced the concept of beta, a measure of volatility relative to the market.
The impact of these two papers is still being felt today.
US pension funds used Markowitz’s framework as the starting point for investment strategy. They converged on a mix of 60% equities and 40% bonds. Investors have broadened their horizons to other asset classes, but many still reference themselves against this benchmark.
Taking Sharpe’s thinking to its ultimate conclusion led to the birth of passive investing.
Diversification 2.0: adventures in equities and bonds
Four trends combined to drive a broadening of investments in the 1980s and 90s:
- deregulation of financial markets
- rapid growth in emerging markets
- financial innovation
- academic ‘discoveries’.
The Bretton Woods system of fixed exchange rates ended in 1973, ushering in an era of currency volatility. Countries abandoned the capital controls. Investors responded by increasing exposures to overseas equities.
In 1981, Antoine van Agtmael of the International Finance Corporation coined the phrase ‘emerging markets’. Investors had observed three decades of rapid economic development in Japan. They saw the ‘Asian Tiger’ economies – Hong Kong, Singapore, Korea and Taiwan – successfully adopt similar industrialisation strategies. This triggered an asset allocation shift from developed market to emerging market equities.
Strong economic performance in the emerging world also improved debt sustainability. Emerging market debt enjoyed strong institutional inflows.
Financial innovation in the US led to the creation of three new markets.
- The mortgage-backed securities market came into existence in 1968. Today, these securities make up more than a quarter of the Bloomberg Barclays US Aggregate Index of investment-grade bonds.
- The high-yield bond market took off in the 1980s. A leveraged buyout boom created a steady supply of bonds.
- The leveraged loans market developed in the late 1990s. Loan documentation was standardised, allowing a secondary market to evolve.
Academic studies uncovered two styles of equity investing that attracted significant attention. A 1981 study by Rolf Banz identified the strong historic performance of smaller companies. Investment managers responded by launching a number of dedicated smaller companies funds. In 1993, Eugene Fama and Kenneth French published research on a three-factor model. This included ‘value’ alongside ‘size’ and ‘market’ factors. US investors started to diversify across value and growth managers.
By the turn of the millennium, investors were diversified across:
- domestic and international equities
- value and growth stocks
- large-cap and small-cap stocks
- developed and emerging markets
- government, mortgage and corporate bonds
Yet this mix was still a blend of equities and bonds. This strategy was stress-tested when the technology bubble burst in 2000. Equity and credit markets fell in tandem. Widening credit spreads meant the more diversified fixed income exposures lagged behind government bonds. Compared to the two-asset 60/40 allocation, the more diversified strategy proved more vulnerable to a severe market decline. Correlations between alternative assets increased during times of stress.
Diversification 3.0: the Yale model
One pioneering portfolio manager emerged from the technology bust with a lasting legacy. Under the leadership of David Swensen, the Yale Endowment generated positive returns in 2001 and 2002. This came on top of strong returns over the previous decade. Investors around the world tried to imitate his strategy; introducing exposures to alternative assets.
Yale’s alternative assets fell into three categories: absolute return (or hedge funds); real assets (or property and natural resources); and private equity.
Hedge funds and private equity managers employed complex investment strategies. Their funds were unregulated investment vehicles. Due diligence required specialist knowledge. A fund-of-funds industry grew out of the demand for an expert view.
Investing in real assets also proved challenging. The US REIT (Real Estate Investment Trust) market provided one accessible structure. This was replicated in other jurisdictions.
Once again, a severe bear market tested the benefits of diversification. The global financial crisis exposed the high correlation of many hedge fund strategies to equities – at least during periods of market stress. Many private market strategies suffered liquidity crises. Commodity prices crashed as the collapse in economic growth slashed demand. The drawdowns experienced by these more diversified multi-asset portfolios once again left investors questioning their diversification strategy.
Diversification 4.0: alpha, beta and beyond
Where does that leave diversification today? Two trends have reshaped investment strategy over the decade since the financial crisis. First, investors have gained a better understanding of a broader range of asset classes and strategies. This has allowed them to incorporate new asset classes and strategies in their multi-asset portfolios. Second, advances in quantitative techniques have increased the toolkit for both risk management and return generation.
The aftermath of the crisis created a growing need for capital in markets previously dominated by hedge funds and other specialist investors. Banks were reluctant to lend. Asset owners were reluctant to place their investments in expensive and complex hedge fund strategies. That left a gap in the market.
Specialist investors started to offer simpler exposures to alternative forms of credit. The range of funds offering exposure to real assets increased. There were also growing opportunities to finance more specialist markets – insurance-linked securities, healthcare royalties and litigation finance. Investment in listed vehicles offering exposure to these alternative investments grew rapidly. These are described in more detail in part II, A guide to alternative asset classes.
Mainstream asset managers also adopted a number of the techniques developed by hedge funds. These included combining long-only and long-short exposures across a broad range of markets.
Advances in quantitative techniques provided investors with a better understanding of the underlying drivers of returns – and the associated risks. Fund managers responded by isolating these underlying factors. Equity portfolios now offer targeted exposure to factors such as size, value, momentum, quality and low volatility.
There are three possible sources of return from investing in a factor over the long-term: fundamental, behavioural and structural. A fundamentally-driven return is earned for taking on higher risk – for example the higher yield on offer from higher risk bonds. Behavioural returns are generated by strategies that profit from the predictable herd-like behaviour of the average investor. Structural returns are created when investors become forced buyers or sellers of securities because of the rules they operate under. These factors can be combined in a way that improves diversification.
Quantitative analysis provides a wider dashboard of risk measures and techniques. These help investors understand the many dimensions of diversification.
The benefits (and limits) of diversification
Will Diversification 4.0 deliver advantages over previous models? To answer this, investors must first decide what they should expect from a diversified multi-asset portfolio. Are they diversifying to protect their portfolios against bad times? Or are they looking for long-term returns from an expanded investment universe?
There are four assets that investors typically use to hedge against bad times.
- Domestic government bonds can protect investors against the risks of deflation.
- Holding cash reduces portfolio volatility and gives the option to buy at lower prices during market setbacks.
- Gold typically performs well when the threat of inflation increases, or political uncertainty rises.
- Investors can purchase options whose value increases when the underlying asset falls in value.
These strategies share one common feature: they reduce long-term return potential. Government bonds and cash offer return premiums below those of equities and corporate bonds. Gold has historically been a store of value rather than a source of returns. Option strategies are a form of insurance. They deliver a positive expected return to the seller of the option rather than the buyer.
By contrast, a diversified portfolio of alternative assets can generate returns comparable to traditional risky assets: equities and corporate bonds. Greater diversity can bring greater certainty in returns over the long term. A broader investment universe increases the possibility of identifying undervalued assets.
What are the limits of diversification? Economically sensitive assets suffer simultaneously during recessions. Illiquid assets can be marked down in price when liquidity becomes scarce. Less economically sensitive assets can provide genuine diversification, but may come with other risks. A dynamic approach to asset allocation can reduce risk but increases reliance on manager skill. So too do some of the techniques adopted from hedge funds. Risk models provide an objective view of a portfolio’s risk exposures but achieving effective diversification still requires judgement.
What is the future for diversification? We see six trends that are reshaping portfolio construction.
First, the shift from traditional to alternative asset classes is set to continue. The regulatory pressures for banks to increase equity capital will restrain bank lending. In addition, the nature of investment is changing. Investment in intangible assets exceeds investment in tangible assets in the US and the UK. These investments involve greater uncertainty over expected return. They are more readily financed by private than public markets.
Second, investors are integrating environmental, social and governance (ESG) analysis into their decision-making process. Understanding the risks and opportunities presented by ESG issues is a fundamental ingredient of investment, alongside traditional analysis.
Third, rapid economic progress means the ‘emerging market’ label no longer captures the whole story. Emerging economies account for 60% of global activity. Yet their financial assets make up only 10% of the global financial system. As these markets increasingly open up to investors, asset owners will need to gain access to the full range of investment opportunities to provide true diversification.
Fourth, advances in computer science allow a more granular analysis of diversification. However, quantitative risk models continue to have their limitations. A qualitative assessment of risk and return will remain vital to achieving effective diversification.
Fifth, regulatory regimes are modernising in many countries. For insurance companies and pension schemes, this exposes any mismatch of assets and liabilities. They will need to embrace a more sophisticated approach to risk management.
Sixth, individuals will have to take more responsibility for their financial futures. Neither the state nor their employers will provide generous pensions. The asset management industry can help. It can provide the right tools, solutions and advice. These solutions must include making this broader range of investments accessible to all.
Increased diversification brings increased choice. Benefiting from this more diversified approach requires skill and experience in a broader range of investments. This extra effort can bring rewards. If done well, diversification can lead to improved long-term returns delivered in a smoother fashion.
So was Markowitz right to describe diversification as "the only free lunch in finance"? Not a free lunch perhaps, but definitely a healthy balanced diet.
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This is a good summary of the evolution of portfolio management. I would add the challenge of capacity in the alternative space. We are already seeing crowding in PE and real assets.