Diversification is a key building block of successful long-term investing and has been called “the only free lunch in finance.”¹ While its origins can be traced back millennia, it has developed dramatically in recent years as markets have grown and new instruments emerged. But now with both equity and bond valuations very high, the diversification challenges to investors have risen. In this article, we track recent developments and show how to manage diversification today.
What is diversification?
Diversification² enables investors to moderate their portfolio risk while still generating returns. This is done by combining assets that often react differently to similar risks. For example, bonds, currencies, and gold have had a negative correlation with equities over the last decade. While US equities have returned nearly 10% a year on average, bonds have returned 4.5%, but with less than a fifth of the risk.
The four big diversification developments
Practical diversification has changed dramatically in the last forty years from the classic 60:40 portfolio. As markets globalised, new asset classes rose, and we learnt to slice asset classes in different ways. We highlight four big changes, and the outlook today.
- The original 60:40 portfolio. The initial focus in the 1970s was on simple diversification across the two most common asset classes: equities and bonds. A 60% domestic equities allocation for the long-term capital return, balanced with 40% in bonds for their downside protection in difficult times along with a reliable yield. Today this can be proxied by the SPDR S&P 500 equity (SPY) and Vanguard total bond market (BND) ETF’s.
- Going international. The 1980s saw the growth of international diversification, across equities and bonds, and the rise of currencies as an asset class. This was driven by the abandonment of capital controls and fixed exchange rates in the 1970s, and the rise of emerging markets — with the term itself coined in 1981.These can be proxied today via iShares MSCI EAFE (EFA) and iShares MSCI Emerging Markets (EEM) ETF’s.
- The endowment model. The 1990s saw diversification across more asset classes, particularly less liquid ones, pioneered by David Swensen at Yale University. Known as the “endowment model,” it invested outside of traditional equity and bonds and in private equity, hedge funds, real estate, commodities and other less liquid alternatives. Yale saw 13% returns a year in Swensen’s 35 years in charge. Today, under 10% of the portfolio is invested in traditional domestic equity, bonds, and cash. Alternatives could include SPDR Gold (GLD) and Vanguard Real Estate (VNQ) ETFs.
- Factor investing. The 1990s also saw an acceleration in using quantifiable characteristics, or “factors,” to determine asset returns, aided by increased computing power and quantitative techniques. These factors included size (small-, mid-, large-cap), value and growth, price momentum, leverage, and profitability, among others. Examples of factor ETFs are iShares Russell 2000 (IWM) and Vanguard Value (VTV) ETF.
More development today — Crypto, ESG, and liquid alternatives
These changes have not stopped. Over the last decade, we have seen the emergence of
Cryptoassets: This has grown into a $1.3 trillion market cap asset class, led by Bitcoin, and is seeing gradual institutionalisation It has a history of both very high risk-adjusted returns and low correlations as compared to other asset classes. On eToro, diversified cryptoasset exposure is available with @CryptoPortfolio and @CryptoEqual.
Environmental, social, and governance. Non-financial analysis has surged in importance in the last decade, led initially by corporate-governance considerations, and now by environmental concerns. Governments are seeking to limit carbon emissions, consumers are voting with their wallets, and investors are allocating to “green” investments. For examples, see the @RenewableEnergy and @Driverless portfolios on eToro.
Liquid alternatives. We are also seeing a surge of new investment vehicles, offering access to traditionally private or very specialist markets. Assets such as infrastructure (speciality REITs), preferred debt, master limited partnerships (MLPs), litigation finance, and hedge fund long/short. For examples, see Invesco preferred (PGX), and Alerian MLP (AMLP) ETFs.
Challenges in perspective — diversification still works
Challenges to diversification and the traditional 60:40 portfolio are high. US equity valuations are significantly above long-term average levels, while long-term bond yields have been falling for thirty years and are now below even the level of inflation. Money market rates are negligible with monetary policy rates at zero or lower globally. The combined earnings yield and bond coupon on a traditional US 60:40 portfolio was a little over 3% in mid 2021, compared to over 10% in the mid-1980s.
Large segments of relative value remain, however. International equity valuations were on the largest P/E valuation discount versus those of the US in over a decade as of mid-2021, and led by emerging markets. Similarly, US value stocks are on a historically large discount to growth stocks, with the largest value component — Financials — the cheapest sector in the market.
Even now the power of diversification is on show. Commodities have the poorest average long-term return of any asset class, with a 4% annualised decline, but have rebounded over 20% in 2021. Similarly, Value has recently reversed in part a dramatic decade of underperformance. Bonds have posted a rare negative return in the first half of 2021, but have been more than compensated by near double-digit returns from alternatives such as real estate investment trusts, and factors such as small caps.
More need than ever; more alternatives than ever
The bad news is that investors’ need to diversify today is greater than ever, and this often requires looking beyond the obvious. The good news is that diversification still works, and more asset class alternatives and investment options are available than ever before.
- Economist and Nobel Prize winner Harry Markowitz
- eToro posts on diversification: Inflation and diversification, Diversification the best bet against loss aversion, Why is portfolio diversification essential.
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