On 10 Aug, the MSCI World Index closed 13.3% down from the start of the month, and investors feared another October 2008, where many asset classes experienced large declines at the same time.
During the month, as in most market crises, diversification provided a great deal of portfolio protection. While global and emerging equities ended the month down 7.0% and 11.2% respectively, global fixed income and emerging bonds were up 1.2% and 0.9% respectively. Alternative asset classes also cushioned equity falls with commodities up 0.7% and managed futures down 1.5%, while hedge funds fell by 2.2% and real estate declined 5.6%.
Diversification has the key benefits of reducing portfolio loss and volatility, and is especially important during times of increased uncertainty. Modern Portfolio Theory, for which Harry Markowitz was jointly awarded the Nobel Prize in 1990, provides the academic bedrock for diversifying portfolios. By combining assets that are not perfectly correlated, the risks embedded in a portfolio are lowered and higher risk-adjusted returns can be achieved. The lower the correlation between assets, the greater the reduction in risk that can be derived.
The logical extension is to diversify to include exposure to all available asset classes. Economists and financial academics refer to the “Market Portfolio” as the combination of all assets classes that generates the highest risk-adjusted returns. This portfolio is massively diversified and continually changing, and for this reason it is not possible to own in practice. Nevertheless the Market Portfolio provides a useful guideline for the reduction of risk: to diversify as much as possible amongst uncorrelated assets. This diversification should not be restricted to one country but should include all asset classes globally.
The large US university endowment funds, particularly the ‘super endowments’ of Harvard and Yale, are some of the best proponents of diversified investing. They have consistently achieved high investment returns and low volatility owing to their multi-asset approach to investing, their strategic approach to asset allocation, and their significant exposure to alternative asset classes. While the financial crisis of 2008 negatively impacted the performance of the US endowment funds, their long-term investment strategy has prevailed to the extent that risk-adjusted returns remain well above the returns of traditional portfolios.
The benefits of global diversification are illustrated in the table, which considers five portfolios, with diversification increasing systematically. Even when diversifying across two asset classes, investors can achieve a significant reduction in risk. However the greatest benefits are derived by including alternative asset classes – Portfolio 5 invests across eight asset classes, and this diversification results in a 48% reduction in volatility relative to Portfolio 1 respectively and 46% reduction in the maximum loss, as well as an improvement in portfolio returns.
The main benefit of diversification is a reduction in risk. The peak-to-trough maximum losses of Portfolio 5 are nearly always below those of the other portfolios (see line chart) and recovery times are shorter. This is particularly evident during the equity bear market of August 2000 to January 2003, when global equities fell by 44%, Portfolio 3 would have declined 17% and Portfolio 5 just 8%. Additionally, Portfolio 1 took 38 months to recover from its lowest point, while Portfolio 5 took 16 months. Even over the 2008 subprime crisis, global diversification helped to mitigate losses; global equities fell 49% over this period while Portfolio 5 declined by considerably less (26%).
Historical evidence and our own experience continue to demonstrate that investors are well served at times of market shocks or sudden drawdowns, by maintaining a widely diversified portfolio. If financial history teaches us anything, it is that past events are often not repeated into the future. However, while the nature of future market shocks may not be predictable, evidence overwhelmingly suggests that the safeguards afforded by diversification are.
