Diversification: Learning to grin and bearing it

23 October 2013   Category: News, Global, USA   By Asia Asset Management

Are institutional investors justified in asking themselves why they bothered to pursue highly diversified portfolios rather than just simply sticking with US stocks and bonds? A valid question, as US equities have outperformed just about everything recently. 
According to Why Did I Diversify?, a new paper from institutional investment advisor Cambridge Associates, those with highly diversified portfolios – for example, large university endowments with allocations to alternative assets like private equity and hedge funds and emerging market securities – should feel confident staying the course. 
"Simple US equity or stock/bond portfolios have outperformed highly diversified portfolios recently. Yet the long-term track record is clear: Highly diversified portfolios have delivered consistently superior returns over decades," said Cambridge Associates’ managing director and report co-author Celia Dallas. She noted that, since 1990, US$100 million growing at the rate of the average large college and university endowment would have increased to $791 million – a 9.2% average annual compound return – through June 30, 2013. The same $100 million invested in an undiversified portfolio of 70% US equities and 30% US bonds would have only appreciated to $700 million (8.6% AACR) over the same period. 
"Diversification is the tortoise, and concentration is the hare," she said. "The tortoise is slow and steady and often wins the race, while the hare takes big leads and then falls behind, rarely winning over the long haul." 
The report cites reasons and evidence why the tortoise, i.e., the highly diversified portfolio, is a solid bet... 
Highly diversified portfolios tend to suffer less than equities during down markets while participating in more of the upside than high-quality bonds. In other words, by never suffering the worst returns, highly diversified portfolios can register strong performance over the long run, even without ever experiencing the best returns during certain periods.
Highly diversified portfolios can typically diversify into investments with higher return potential, seeking value-added returns through strong manager selection, particularly in alternative assets.
A comparison of the top and bottom deciles of endowments, sorted by performance over the last decade, shows that the top performers had significantly lower allocations to US stocks and bonds and higher allocations to hedge funds and private investments of all sorts. This is true despite the exceptional performance of US stocks since 2008. (Note: Highly diversified investing is for institutions with long time horizons.) 
For institutions that spend from their portfolios, a diversified strategy has allowed for both an increase in market values and, at the same time, an increase in spending.
"Given that US equities and US bonds are overvalued, we would not bet on their out-performance persisting into the long term. As for bonds, most varieties are so expensive that we believe it will be challenging for them to generate positive returns after inflation. Yet we remain constructive on alternative assets and the ability of skilled investors to add diversification and value through thoughtful portfolio construction and manager selection. That's why, over the long term, we're betting on the tortoise," Ms. Dallas said.