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Concentration, not diversification, has been rewarded for most of 2018. A metric you’ve probably never heard of helps give some insight.
Diversification is one of the guiding principles of portfolio construction, but year-to-date market performance (especially prior to the October correction and the midterm elections) has undermined this well-established approach. The portfolios that have been rewarded as of late are U.S. portfolios concentrated in a few key stocks, global portfolios concentrated in U.S. stocks and asset allocation portfolios concentrated in equities.
An important method for understanding the historical context of these recent conditions is measuring the concentration of asset class performance (i.e., how unusual are the levels of narrow performance?). One tool that can help us measure the breadth of market performance is a diffusion index. Here’s how it works:
This measurement can be used to examine both individual stocks and broad assets in a portfolio. When the result is high, it means that more than half of the securities or assets are doing better than the index. And when it’s low, it means that less than half are doing better than the index.
Using this tool, we looked at the historical level of concentrated performance among 12 different asset classes that frequently comprise a multi-asset approach: U.S. equity, international developed equity, emerging market equity, U.S. Treasuries, international developed Treasuries, emerging market bonds, U.S. investment grade, U.S. mortgage-backed securities, U.S. high yield, global inflation linked bonds, REITs and commodities.
Our analysis revealed that the market was very narrow for most of this year. In this environment, a diversified approach suffers and any kind of risk allocation strategy — which favors lower volatility assets, like bonds, compared to higher volatility assets, like equity — also underperforms.
Why diversification still benefits investors
The obvious question is where do we go from here? Of all the arguments for diversification, the one we believe is most important in this environment is drawdown protection. We are proponents of diversification to help provide downside protection in a portfolio, but consider a diversification approach based on the allocation of risk, not capital.
Risk allocation assigns portfolio weights based on historic asset risk levels and may have a leveraged bond component. And it could improve the drawdown benefit of a globally balanced portfolio. As shown below, bonds and other asset classes mitigated drawdown in the early 2000s. The benefit of this diversified risk allocation approach wasn’t as apparent during the 2008 global financial crisis, but there was a faster recovery from the depths of the drawdown—and this benefited a risk-balance investor in the long term. More recently equity has done so well that a simple global balanced approach has outperformed anything with leveraged bonds (like risk allocation).
Most of 2018 rewarded investors with concentrated bets in equities, and we’ll likely see these periods again. But unless someone can perfectly time the ebbs and flows of the market, the risk of significantly greater drawdowns increases by staying concentrated.