The 2008 crisis was unique in terms of its speed, the jump in correlations and the fall in liquidity. Multiple asset-class returns have headed in the same direction: down. With the exception of government bonds, no asset class – including alternatives – protected investors during the credit crunch. The scope of the sell-off in multiple asset classes during the crisis is unprecedented in modern times.
The broad-based decline is unusual because it caused several concepts of conventional wisdom in finance to be called into question. For example, during this crisis, many fixed-income assets that had been considered relatively safe suffered to some extent; and some alternative asset classes that held up well during previous bear markets in stocks tumbled significantly.
One of the key rationales behind most classic multi-asset class strategies is the supposed diversification benefit offered by the relatively low historical correlations between asset classes. Following the sell-off across many asset classes during the credit crisis, asset allocation strategies receive greater scrutiny and many investors have begun to ask: is diversification dead?
This perfect storm has been driven by the worst credit market crisis and the biggest threat to the global financial system since the 1930s. Coupled with the steep global economic downturn it precipitated, these developments led to a crisis of confidence that provoked many investors to flee to safety and forced many financial entities to sell other assets in order to de-leverage their balance sheets.
Diversification is illusory when the entire financial system is imperilled. In these situations, systematic risk dominates and correlations generally rise sharply, making the portfolio riskier than it initially appeared. Moreover, there has been implicit leverage operating across different asset classes, particularly via hedge funds, which has pulled asset dynamics further together.
Therefore, many classic multi-asset mandates, followed by university endowments and pension funds, failed to protect investors during the current crisis and need to be reconsidered. Specifically, high volatility and correlation revealed previously unnoticed risks in the asset allocation which have to be addressed through enhanced risk management measures.
Many industry practitioners have suggested that there is a need to move away from the classic bond/equity benchmarks towards a more dynamic asset allocation, to help manage risk over the long term.
In this article, we consider whether diversification benefits are in fact diminishing by investigating the issues associated with traditional asset allocation strategies, which tend to reduce the efficiency and effectiveness of portfolio diversification.
We then propose a new perspective on asset allocation to address the inefficiency and ineffectiveness of traditional portfolio diversification techniques.
Diversification Is Not Dead
Fundamentally, it is important to remember that over the short-term, diversification at times may not appear to be effective, but over longer time horizons, it has been valuable, as it avoids generating overly-concentrated portfolios due to poor input estimation.
Most portfolio managers appreciate that the value-added is ultimately dependent on their ability to correctly forecast asset class returns. Managers work hard to create valuable information about future returns, but may not pay as much attention to the estimation errors in the portfolio construction process. Specifically, estimates of long-term expected returns are uncertain, which could affect forecast results in a significant way. A risk-averse investor is interested in realised returns since the start of his or her portfolio, even though they maintain a long investment horizon.
While all asset classes can suffer at the same time during extreme market conditions, a well-diversified portfolio may still reduce portfolio losses, and smooth out return volatility over the long-term. Therefore, diversification can protect an investor against concentration risk in their portfolios.
Diversification also provides the benefit of “preparing for a rainy day”, as it tends to provide protection by building up a buffer of less volatile performance during normal times.
Traditional failings
Most traditional techniques to reduce concentration risk in a portfolio might generate false diversification and need to be reconsidered in a more robust way. Traditional asset allocation strategies, especially those based upon the mean-variance framework proposed by Markowitz, are known to suffer from serious drawbacks when applied in practice.
First, optimal portfolios tend to be overly concentrated in a very limited subset of the full assets or securities spectrum. Second, the mean-variance solution is very sensitive to the inputs as small, statistically and economically insignificant changes in these parameters, and notably in expected returns (Merton, 1980), can lead to a significant change in the composition of the portfolio.
Therefore, the resulting optimal portfolios tend to be overly concentrated in a very limited subset of the full asset classes spectrum and might not represent a truly risk-diversified portfolio. To avoid creating an overly-concentrated portfolio, investors usually apply the weight constraints to the underlying asset class components.
