June 13, 2022

Diversification as a Hedge to Volatility, Part 1

Individual investors with public market portfolios are increasingly frustrated. A complex investing landscape characterized by extremes in liquidity and rates, global uncertainty, and inflation is directly challenging the traditional mix of stocks and bonds focused on capital appreciation and current income, plus thwarting traditional methods for diversifying portfolios in ways that hedge against such volatility and uncertainty. With this, unregulated emerging asset classes may only be exacerbating the problem.

A tidal wave of monetary stimulus from central banks — from the Global Financial Crisis in 2009 through the recent COVID pandemic — led to higher equity valuations (particularly the case for fast growing technology companies whose stocks often thrived as interest rates fell to record lows). However, massive liquidity infusions into public markets led to increased correlations between investment returns across equity strategies and traditional asset classes such as stocks and bonds. This directly lowered the benefit of diversification. Stretched equity valuations also limited additional return potential and led to sizable volatility when the COVID pandemic began, while bond yields were unattractive.

Investors of various degrees of sophistication seeking outperformance — whether in terms of capital appreciation or income — have gravitated toward riskier traditional investments, such as IPOs of companies that don’t generate positive cash flows, new asset classes such as cryptocurrencies and NFTs, or SPACs for upstarts with unproven business models. While the wealthy are often early to allocate limited exposure to new asset classes (and better able to absorb any losses), new investors chasing outperformance with concentrated positions of their limited savings can suffer substantial financial setbacks. Now, with central banks withdrawing support for markets by raising interest rates, companies’ profit margins, earnings and valuations are all likely to contract; and current bond holdings are unlikely to provide a hedge against rising inflation.

However, investing in private market alternatives may complement traditional portfolios by offering the potential for both enhanced returns and lower volatility. Such alternative investments, though, have been primarily accessible to institutions such as pension plans and university endowments with meaningful exposure, as well as to high-net-worth investors who have been gradually adding exposure. But individual investors largely have been left behind due to the high levels of income or net worth required to invest in alternatives. Additionally, high minimum investment thresholds and limited return of capital opportunities have hindered individuals’ allocations to alternative investment strategies.

What is diversification and how does it improve investment returns?

Diversification is a strategy that constructs portfolios of investments to balance performance based on their different risk profiles and return potentials. The goal is to achieve higher long-term returns while mitigating downside risks from market-related volatility, or due to poor performance from concentrated individual holdings.

By diversifying portfolios, the positive performance of some assets may offset the poor performance of other holdings based on their underlying fundamentals and investor sentiment. Diversification also takes into account how investments respond differently, relative to each other in different market environments.

Diversification can be achieved by investing across different asset classes, as well as across different holdings within asset classes. For example, investors can invest in stocks and bonds with an underlying mix of growth and dividend-paying stocks, as well as corporate and government bonds. A portfolio of as few as 25 to 30 stocks provides a high degree of diversification. Tech-enabled industry disruptors can often exhibit outsized performance based on high multiples for expected future growth, while established companies may appreciate more slowly while paying consistent dividends. But in times of market volatility or economic recessions, companies that don’t generate cash may experience precipitous declines while dividend-paying stocks become more attractive due to the income received.

The steady income from adding bonds to a portfolio can enhance diversification. When compared to government bonds, which offer less risk, corporate bonds pay higher interest while having varying degrees of increased risk. In times of volatility or recession, however, corporate bond prices may decline due to the risk of bankruptcy while government bond prices rise as investors seek safe havens.

Stocks and bonds often trade inversely to each other. Strong economic growth can generate inflation, causing stocks to rise but bond prices fall due to higher interest rates. Adding real estate, commodities and international securities can broaden diversification. The degree to which asset classes and the holdings within an asset class change in value (relative to or inversely from each other) is known as correlation. The less correlated a portfolio’s holdings are, the greater the diversification benefits. However, certain factors can cause correlation benefits to break down. The wave of financial support provided by central banks these past years has tended to lift all boats, lessening the range of returns from different assets and asset classes. The return of an investment relative to market volatility is known as beta. Positive liquidity-driven markets led to higher returns from beta and thus higher correlations.

In addition, economic conditions may cause expected correlations to change. Weakening economic growth as inflation rises can cause the prices of both stocks and bonds to decline, rather than to move inversely to each other, as in the scenario above. Furthermore, the volatility associated with declining markets can also cause correlations to rise, as investors may seek to sell assets indiscriminately to avoid market risk.

As liquidity-driven markets subside, investors may look to add relatively uncorrelated alternative investments such as private equity, venture capital, and hedge funds to de-risk their portfolios, while preserving the potential for future gains. In Part 2 of this series, we’ll discuss how alternative investments can help achieve better long-term outcomes for portfolios when used alongside publicly available securities.

Follow Poolit on Linkedin for more information on alternatives and consider signing up for our waitlist at www.thepoolit.com to access top alternative investments when we launch our app this Fall.

Notes:

1. S&P GSCI Agriculture; Artprice Contemporary Art Index; S&P/Case-Shiller U.S. National Home Price Index; iShares Gold Trust (IAU); Rare Whisky Apex 1000; NCREIF Farmland Index; Liv-ex 1000; PWCC 500; Abrdn Physical Platinum Shares ETF (PPLT); Invesco DB Oil Fund (DBO); Bitcoin (BTC); S&P 500 (SPX); iShares 7–10 Year Treasury Bond ETF (IEF)