Morningstar Advisor - June/July 2013 - (Page 36)

Spotlight Beware the Lure of Diversification By Michael Coop To truly diversify a traditional portfolio, alternative investments need to be cheap and behave differently than stocks and bonds. Much like the Greek sailors who were lured to shipwreck by the enchanting music and voices of the Sirens, investors have been seduced by the call of diversification into buying overvalued, cyclical strategies marketed as alternative investments and paying high fees to obtain them. The superior performance of commodities, infrastructure assets, and hedge funds over equities during the 2000–2002 bear market attracted a lot of capital to these areas in ensuing years. But all performed far worse during the global financial crisis of 2008 than they did in the earlier downturn; losses for commodities and infrastructure were on par with those of equities (Exhibit 1). Adding these assets to a traditional stock/bond portfolio barely improved the portfolio’s performance. From 2000 to 2012, diversifying into alternatives would have increased returns by a meager 0.2% annualized and not reduced risk (based on a 10% allocation equally split between hedge funds, infrastructure, and commodities, funded pro rata for a 50% equity/50% bond portfolio). This outcome is a far cry from what most investors expect when they use alternative investments as diversifiers. Adding them to a traditional portfolio is supposed to improve outcomes in ways that would not be possible simply by varying the mix of stocks and bonds. The aim is to improve risk-adjusted returns, so that for a given amount of risk, returns should be higher, or for a given return, risk should be lower. Two Conditions of Diversification The risk investors should be most concerned with is the permanent loss of capital rather than volatility. For diversification to work, an alternative investment must meet two conditions: 1. It needs to behave differently from equities and bonds over a full market cycle. Whatever drives alternatives’ underlying cash flows and changes in valuation cannot be the same drivers of the behaviors of equities and bonds. 2. It should be priced low enough to generate a return high enough to improve the portfolio’s performance, taking into account valuation and fees. An alternative investment’s returns do not need to be higher than those of equities or bonds, providing the investment does behave differently. But adding it won’t improve 1 Ibbotson, Roger G. and Peng Chen, “Long Run Stock Returns: Participating in the Real Economy,” 2003 36 Morningstar Advisor June/July 2013 total portfolio outcomes if it suffers a large fall in value, as tends to happen after surges in popularity and prices. Is It Really Alternative? The first condition for getting diversification is very important; many funds are promoted as alternative investments but there is no widely accepted definition of “alternative.” Investors need to understand what drives the prices of equities and bonds before they can determine if the alternative investment is giving them more of the same, or something different. When equities and bonds suffer large losses, will the alternative investment behave the same way or will it provide the needed diversification at that time? Let’s look at some drivers of equity and bond returns. Equity Returns Dividends and corporate earnings per share have been the key drivers of real equity returns over the long term.1 Income comes from dividends; capital return comes from changes in share prices, reflecting 1) inflation, 2) growth in corporate earnings that accrues to shareholders, and 3) changes in valuation (for example, how much investors pay for future cashflows).

Table of Contents for the Digital Edition of Morningstar Advisor - June/July 2013

Morningstar Advisor - June/July 2013
Letter From the Editor
Not Your Values
How Do You Use Alternatives for Clients?
Working to Build a Niche
How to Put Buffett’s Investing Philosophy into Practice
Sophisticated Strategies for the Masses
Investments á la Carte
Investment Briefs
The Percentile Trap
Defense Firms Will Stay Aloft
Beware the Lure of Diversification
Using Alternatives in Practice
Managed Futures and Cash Rates
The World Is Getting Grayer
Waiting to Pull Up Anchor
The Price of Managing Volatility
Let’s Get Back to Basics
Our Favorite Mutual Funds
50 Most-Popular Equity ETFs
Undervalued Stocks With Wide Moats
Mutual Fund Urban Myths

Morningstar Advisor - June/July 2013