Is Portfolio Diversification Dead?

We have all heard of the virtues of diversification, learned about them in school, and have Markowitz’s quote (“the only free lunch in finance”) tattooed on us. But since 2010, in one of the strongest bull markets ever (we can debate when a bull market starts at a later time), does it still make sense to diversify your portfolio? (Spoiler alert: As we addressed in last week’s blog, those who avoid diversifiers in their portfolios will not be properly prepared for the future. See below for the proof.)

 

Let’s compare 4 simple portfolios, using monthly data from 1/1/2000 to 7/31/2018:

  1. Portfolio 1: 100% S&P 500 (aka, the original HODL)
  2. Portfolio 2: 100% S&P 500 + 5% OTM (out-of-the-money) S&P 500 put options (aka, the insurance portfolio)
  3. Portfolio 3: 60% S&P 500 + 40% Bloomberg Barclays US Aggregate Bond Index (aka, the standard portfolio mix)
  4. Portfolio 4: 50% S&P 500 + 40% Bloomberg Barclays US Aggregate Bond Index + 10% SocGen Trend Index (aka, the standard CTA portfolio mix)

Table 1: Statistics from 1/1/2000 to 7/31/2018

Portfolio 1 Portfolio 2 Portfolio 3 Portfolio 4 Aggregated Bonds CTAs
Annual Return 5.59% 3.48% 5.59% 5.63% 4.86% 4.96%
Standard Deviation 14.42% 11.54% 8.63% 7.24% 3.40% 14.03%
Return/Deviation 0.387 0.301 0.648 0.778 1.429 0.353

Over the full history of data, we can clearly see the benefit of having a diversified portfolio. Portfolios 3 and 4 have the same or higher annualized returns with lower annualized volatilities, resulting in higher returns per risk (Ret/Dev -> basically the Sharpe ratio excluding the risk-free rate). Portfolio 4, with a 10% CTA allocation, outperformed the three other portfolios, including the standard portfolio mix (Portfolio 3), over the timeframe. The insurance portfolio (Portfolio 2) was the worst performing, costing a little more than 2% annually (insurance sure is expensive). These statistics are over a full market cycle and Portfolios 3 and 4 are apparently benefiting from a time when equities struggled, which takes us to Table 2.

Table 2: Statistics from 1/1/2000 to 12/31/2009

Portfolio 1 Portfolio 2 Portfolio 3 Portfolio 4 Aggregated Bonds CTAs
Annual Return -0.95% -1.39% 2.25% 3.32% 6.33% 8.22%
Standard Deviation 16.13% 12.58% 9.78% 8.02% 3.83% 16.08%
Return/Deviation -0.059 -0.110 0.230 0.414 1.651 0.511

In the 2000s, the S&P 500’s return annualized at about a 1% loss per year while fixed income and CTAs annualized over 6% per year, so obviously Portfolios 3 and 4 outperformed Portfolios 1 and 2. Even in this period, where the S&P 500 was essentially flat for 10 years, the cost of insurance outweighed the benefit; with Portfolio 2 underperforming the S&P 500 (Portfolio 1).

Table 3: Statistics from 1/1/2010 to 7/31/2018

Portfolio 1 Portfolio 2 Portfolio 3 Portfolio 4 Aggregated Bonds CTAs
Annual Return 13.74% 9.44% 9.61% 8.39% 3.17% 1.27%
Standard Deviation 11.86% 10.04% 6.95% 6.16% 2.75% 11.15%
Return/Deviation 1.159 0.941 1.383 1.363 1.152 0.114

From the start of 2010 to the end of July 2018, the S&P 500’s return has annualized over 13% per year (what a great time to HODL!). With fixed income and CTAs struggling (annualizing about 3% and 1%, respectively), of course Portfolios 3 and 4 are going to lag the S&P 500 (Portfolio 1), on a return basis, during this period. But the diversification of Portfolios 3 and 4 were still beneficial on a risk-adjusted basis (higher return per risk).

Graph 1: Drawdowns from 1/1/2000 to 7/31/2018

Looking at the portfolio drawdowns, the benefits of diversification are even more evident. At the end of February 2009, the S&P 500 (Portfolio 1) experienced its worst drawdown, on a monthly basis, of approximately 50% while Portfolio 4 was down roughly half, at about 26%. That gap makes a huge difference in the “livability” of a portfolio (the ability/probability of sticking with it).

Graph 2: Drawdowns from 1/1/2010 to 7/31/2018

The worst drawdown for the S&P 500 (Portfolio 1) after January 2010 occurred at the end of September 2011, with the S&P 500 being down about 16%; at this point Portfolio 4 was only down about 7%. Just recently, the S&P 500 (Portfolio 1) was down over 6% during two months in February and March 2018 while Portfolio 4 was down about 4%; even the insurance portfolio (Portfolio 2) was down about 6% (that’s not much protection).

Ignoring the fact that no one can predict exactly when this equity market run will end, it still makes sense to diversify your portfolio. Diversification provides better “protection” than portfolio insurance (which is costly) and a better risk-adjusted return than just the S&P 500 (even in a strong equity market).

So…no, diversification is not dead. And it still is the “only free lunch in finance”!

Read more in our last blog, Our Response to Morningstar’s Recent Piece on Liquid Alts >