Perhaps your portfolio is not as well diversified as you think!
Cassie Laymon and Hillary Sunderland, Chief Investment Officer of LightPoint™ Portfolios discuss several factors that contribute to diversification that lowers the risk to your clients.
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Full transcript below.
Transcript
Cassie:
So Hillary, welcome back to another episode of Infrequently Asked Questions.
Hillary:
Thanks, Cassie. Great to be back.
Cassie:
So today’s question that we’re going to be discussing is how many funds are in a well-diversified portfolio? So I think it wise for us to start at Ecclesiastes 11:2 that says, “divide your investments among many places for you do not know what risks lie ahead.” And some versions of the Bible will say seven or eight. And so the question is what risks? It says, you don’t know what risks might lie ahead. So tell me about some of the risks of not having a well-diversified portfolio.
Hillary:
Well, the risks really are that it, well, let me back up a moment. So many investors really just don’t truly understand effective diversification, believing that they’re truly diversified if they just spread their investments across domestic large cap, many small cap, or, also investing in international emerging markets, maybe some bonds. But in reality, you know what they’ve really done with the equity portion of their portfolios, they’ve really just invested in multiple sectors of the equities asset class that are prone to rise and fall with the markets. And so the danger with that is if you’re only invested in asset classes that are highly correlated, meaning that they are moving together with the market, often mimicking each other in terms of how they’re moving, then whenever a trial comes to the market, whenever you start to get some market selloffs your whole portfolio is prone to go with it. And so the danger is that you’re just truly not effectively diversified and you stand to probably lose more money than you would otherwise if you were truly invested. And also when you’re not truly invested, also increases your risk to make mistakes from a behavioral finance approach. So you tend to get more worried whenever everything is falling apart in your portfolio at the same time. And that can cause you to make irrational and imprudent moves in your portfolio.
Cassie:
So I was sharing with you before that, when I got started I was taught to take the Morningstar style boxes and plug one fund into each box. And so based on what you’ve just said, so that would be nine different funds in the equity part of your portfolio, but based on what you just said, that doesn’t necessarily mean I’m well diversified just because I have one fund in every box. They’re all moving in concert together that doesn’t make it well diversified.
Hillary:
Yeah, that’s right, Cassie. So years ago, if you look back to, you know, 1980s, 1990s, owning different types of stocks in your portfolio may have seemed to provide adequate diversification at the time. But that’s less the case today because as the markets have, as the world has become more globalized, the markets have become increasingly correlated as well. So for example, if you were looking at the correlation of domestic large cap to small cap stocks in the 1990s, your correlation was moderate, it was around 0.6. Today, when you’re looking at the large cap domestic versus small cap, your correlation is around 0.9, meaning it’s, they’re almost perfectly correlated to one another. I mean, obviously you’re still getting slightly varying returns between the two asset classes, large cap to small cap, but generally they’re tracking together. And that’s why diversification across asset classes makes more sense than ever because as the global markets have become more globalized, everything starts to move more and more in lockstep. And so it’s very important to look outside of equities, into alternative type investments and also into the bond market as well, which is where I see investors probably making the most mistakes with how their portfolios are allocated.
Cassie:
Well, let’s talk a little bit more about that because I will just say, as an advisor, we think much more on the equity side and then maybe you’re plugging in, you know, a bond fund or two, to balance that out, but that’s kind of your expertise. You have done a lot of work in that area. So talk to us about bonds and fitting that into a well-diversified portfolio.
Hillary:
Sure. Well, at a space case, you know, many advisors and investors believe that, okay, well I just want to make a balanced portfolio. So I’ll put maybe 40% of my allocation into the Barclays Aggregate Bond Index, the rest into equities. And therefore my portfolio is diversified. Now I will say from a stock to bond allocation, you’re somewhat diversified, but you need to also look at the diversification within your bond portfolio. One of the things that investors often miss is that the bond market is a huge market. It’s bigger than the global stock market. If you look at the total debt outstanding around the world, about $110 trillion is what is there in outstanding debt around the world. And the U.S. debt market is only $41 trillion of that. And so if you’re taking the approach that on the bond side of my allocation, I’m only going to invest in U.S. bonds.
And most of the time, people just key in on the Barclays Aggregate Bond Index or investment grade, your opportunity set is now less than 40% of what’s available in the global marketplace. And there are a lot of sub-asset classes within fixed income. There’s at least nine that I could name. You know, you have emerging market debt, emerging market local currency debt, high yield TIPS, you have different currencies. There are a lot of different ways to earn return in the fixed income markets. And so certainly when you’re in an environment, especially like today where the Fed is really moving the markets based on their interest rate outlooks, having that diversification across many, many different bond sectors is really important. And you can add a lot of value to portfolios by really diversifying that fixed income asset allocation.
Cassie:
OK, great. I mean, I think you’re bringing up things that we are just not thinking about all the time and that’s what we really want to do today. So let’s talk about another way to diversify. So some people say, you know what, I’m just into passive investing. And so they’re maybe looking at ETFs, so speak to passive investing versus active investing and how that fits in.
Hillary:
Sure. Well, as an investor, there are merits to both. To me, I think about it more from a portfolio manager’s perspective in that the economy and the markets, they move in cycles. And so if you look at when active tends to outperform passive and vice versa, what you’ll find is there are key times in the market when passive beats active. And there’s a great study by Leuthold Asset Management a few years ago on this. And, really, the five factors for when passive investing beats active are: when large cap stocks beat small cap stocks, when U.S. stocks beat international stocks, when growth beats value, when market cap weight beats equal cap weight in terms of returns, and also when the largest 25 stocks in the S&P 500 beat the smallest set 475 stocks. And so what you have is you have certain market environments when passive investing tends to do very well.
And a lot of that has to do just with how indices like the S&P 500 or the Russell 2000 are constructed. And if you think back to those five factors, I just told you that is what has been in favor for the last few years. Certainly growth has beaten value, large cap has beaten small cap and domestic has beaten international. And so you’ve had, you know, some excess performance in that regard. However things will eventually turn the other way. You know, the early 2000s, you had international beating domestic stocks by a landslide. You had small cap largely beating large cap in the equity market selloff of the tech bubble. And so there are periods of time when active beats passive. So to me, it’s not really a one versus the other type approach that you should have in your portfolios. But what we tried to stress at LightPoint is really having strategy diversification. You know, that one’s going to beat another and sometime period. So have clients invested a little bit in both in order to further diversify the portfolios that way as well.
Cassie:
That makes sense. That makes a lot of sense. So let’s even take it down another level and look at a specific asset class. Like let’s talk large cap domestic. Tell me about your thinking when you’re trying to put together a portfolio and you’re trying to fill in that box, what are the different things that you’re thinking about?
Hillary:
Well, you know, I think at its core, one of the things that we’re thinking about is that, it’s not only wise to invest and diversify globally. Like we talked about not only across asset classes, but also across various investment styles and managers. And so even in the large cap space, if you’re looking at, you know, a few different managers to put into your portfolio, you immediately have access to a lot of different investment styles. You can have a manager that’s passive versus active. You can have a manager that does top down analysis, meaning they’re looking at and forecasting, what’s going to happen to the economy in different parts of the market and then they make their stock selections from that. Or you can have a bottom-up manager where they’re kind of starting from what has the best relative value in terms of their process and selecting from there. You can have smart beta approaches, fundamental, quantitative, all of these approaches have time periods in which they’re in favor and time periods in which they are out of favor.
And so what we like to do at LightPoint is really look at, you know, when we’re picking a large cap manager for our large cap allocation, for example, I’m looking at well, is that a top-down manager and is the other manager we’re using in that space also top-down? Do they have similar views? Because if so, if they get those views wrong and the market falls apart, then your whole portfolio is going to struggle. So we like to find managers that compliment one another in terms of how they’re investing, in terms of, if they’re looking at top down, bottom up, if they’re doing quantitative versus fundamental, low vol versus high beta, there’s a lot of different ways to diversify a portfolio. And so it goes much further than just filling in a particular style box.
Cassie:
So let’s talk about something that is a challenge in the faith-based investing space. So there are a few, really only a handful of companies, that are really devoted to biblically responsible. So advisors might say, okay, I’m just going to build my portfolio using these two fund companies, because they’re the BRI folks. And, you know, we would say we have a lot of funds that we use that we call clean by accident, right? We love our BRI friends, our mutual fund, ETF friends and we use them as much as can. But sometimes if there’s not a slot that can be filled, we find a fund that we would call “clean by accident.” So if someone says, well, I don’t want to do all of this work. It’s a ton of work and that’s not a criticism. It is a ton of work. So I’m going to just use these two or three fund companies and I’ll build my whole portfolio using those. What are some of the risks that they should know about?
Hillary:
Yeah, that’s a great question. So the risks would be, you really need to know how are those managers, if you’re going to choose just one particular fund company or two, how are those managers selecting securities for their portfolios? And are they following a similar investment style and process across all of their funds? An example of this would be if you have a fund family that does solely a top-down approach to investing meaning they are making forecasts on the economy, forecast on interest rates. For example, if they are a bond manager and they’re positioning all of their funds in regard to the economic forecast, and then it’s wrong, your whole portfolio is going to go out of favor, which is going to be difficult for your clients, certainly, when they’re not tracking the industry. So really having a really clear understanding of how the underlying securities are being selected and how that is applied.
And also when will that go out of favor so that you know, that when you have to reposition your portfolio ahead of time, you know, for us, we do use, as you stated, Cassie, we use BRI funds. We also use funds that screen well by accident, as you stated, we also use ESG oriented funds in our portfolios because a lot of those screen out, you know, alcohol, tobacco, gambling, some of the main causes that we are looking for. And so to us, by accessing talent from some of the world’s premier investment managers, we’re really able to get a high level of skill in our portfolios that you probably would not be able to get at a single firm. I am a big believer in that, you know, God has made everybody to have different talents. We all have different gifts and abilities, and it is very difficult for me to agree with the notion that one fund family is very good at investing in every investment class, every asset class that you want to invest in, or have a diversified portfolio. And so by diversifying across those fund families, you can really get wisdom in a multitude of counselors, which is also a biblical principle from Proverbs.
Cassie:
Right. And what you’re saying also, I think, and correct me if I’m wrong, but, if one of those funds falls out of favor, then you can switch in, you know, a different fund and not just be stuck in, like we said, one or two or three fund families. I think that’s important. All right. I’m also going to draw a conclusion here again, tell me if I’m wrong.
Hillary:
Okay.
Cassie:
Over the last few years, it’s been a little bit easier to put together a portfolio because of how the markets have been, you know, kind of up and to the right, but you know, when that falls out of favor, then you might find yourself in a difficult spot with your clients because you are not looking at all of these other things that you’ve talked about today. Just kind of, everything’s been moving very highly correlated together over the last few years, and we’re coming into a time where that potentially may not be true in a cycle.
Hillary:
Yeah. Yeah, that’s correct Cassie. We are getting very late in the economic cycle. And certainly when that happens, you want to be able to position your portfolios to weather the storm and you’re right. Diversification can often be, diversification can be something that clients don’t necessarily like whenever you have really strong up trending markets, such as 2013, when the market was up of 32% or 2017, when you had a very high return in the market, sometimes, you know, diversification any given year can make your returns lower than what you would get if you were just chasing a particular index. But by default, diversification means always saying you’re sorry. Right? If everything in your portfolio is moving in lockstep with the markets, you’re either, you know, there’s really one of two things. You’re either not adequately that diversified, or you are incredibly lucky as an investor. There always should be one part of your portfolio that is not working terribly well, because that means that you are truly diversified as an investor, but that’s an anomaly that most people don’t consider. The logic of it makes sense in that diversification can really help reduce risk over longer periods of time. But the mathematical implication of that is that they’re going to be time periods when parts of your portfolio going to lag, but clients need to take a long term view on that.
Cassie:
Yeah. Yeah. Great. Do you have any closing words for us on that, about your views about diversification? We’ve covered a lot here.
Hillary:
Yeah, I know we’ve covered a lot. I think it’s just really important to look beyond, you know, a lot of the simple strategies that are out there today. It’s very easy to look at a portfolio with, you know, five or six passive ETFs in it and believe, that’s truly diversified for clients. But once you take a step back and you look at the research and how market cycles move, when things go in and out of favor, how globalization has changed correlations over time. I think it’s just really wise to expand your horizon and to look for a truly diversified approach, not with asset class selection, but also with manager selection. What types of managers you’re putting into the portfolio to give your clients a good experience over time? Because in the end, I’m a firm believer that if your portfolios are structured in a way that your clients are not able to stay invested with them over a full market cycle, it’s not a good strategy for the client to be in because behavioral finance shows time and time again, if clients can’t stay comfortable with it in any market type environment, they’re going to bail on you. And if they bail on you or the strategy, they’re probably getting out at the worst time. And so you need from a behavioral finance approach to always find investment strategies, whereby they are able and willing to stay invested in any type of market environment. And that’s what we try to do at LightPoint.
Cassie:
That’s great. That’s great. Thank you for that, Hillary. So if you might find yourself in this situation where, Hey, my portfolios have been doing really well over the last couple of years, but maybe you haven’t looked at diversification in the way that you could be, and hopefully you learn something new today. So if you have questions about the diversification of your portfolio or how you might outsource some of that responsibility, because it’s a lot of work, don’t hesitate to give us a call or you can email me at cassandra@beaconwealth.com.