Is Your Portfolio Truly Diversified?

6 Minute Read

Take full advantage of diversification by understanding where to find truly unique sources of return.

Many investors claim that diversification is the only “free lunch” in investing. By combining assets that behave differently from each other, portfolios can provide the best of all worlds: higher risk-adjusted returns. Harry Markowitz proved it more than 60 years ago when he developed modern portfolio theory, and one would be challenged to find a financial advisor today who does not espouse the concept.

But what does true diversification look like? How do you take full advantage of its promise: lower risk for the same return, or higher return with the same risk? The reality is that, unbeknownst to them, many investors have not fully diversified, despite owning a varied mix of asset classes and investment products. And ultimately, this results in missed opportunities to create more optimal portfolios.

True Diversification vs. Naïve Diversification

The first step to avoiding this same fate is to define diversification and draw the distinction between true and robust diversification and what can be called “naïve diversification.” Naïve diversification is building a portfolio that looks well diversified but consists of underlying holdings that are highly correlated, particularly during times of market stress.

A good example of naïve diversification is a portfolio that holds a number of U.S. equity holdings or even a number of U.S. equity managers. An investor with this portfolio may believe she is quite diversified; however, in reality, one risk will dominate this portfolio: exposure to the market. This example can be broadened further to a portfolio of both U.S. and non-US stocks, which is still dominated by exposure to the market. The U.S. and non-U.S. holdings are simply different flavors of this same risk.

To be truly diversified, investors need to own a collection of assets with different risk drivers, which will act and react differently from each other. So, how do you achieve this “free lunch” promised by Markowitz?

To help, we have provided a breakdown below of five risk-based categories that, in aggregate, represent the investment opportunity set. Everything you own in your portfolio will fall into one, or more, of these categories. Research shows that each one is unique and offers a positive expected return, which means that if you combine them, you can achieve proper and valuable diversification. While each one of these categories deserves its own article – or series of articles – this summary provides the full picture and can help you approach asset allocation and portfolio construction with the right mindset.

Diversifying Sources of Return

The investment opportunity set – five risk-based categories

Primary Risk Factors

Two primary sources of risk – or “factors” – drive the majority of conventional stock and bond portfolio returns and are the foundation of capital markets. These factors dominate a typical portfolio and include the following:

  • Market: Market risk describes the risk you take by exposing your portfolio to the sensitivity of global equities, commonly referred to as beta. The market premium is the excess return an investor earns over the risk free rate, commonly measured by the 3-month U.S. Treasury bill. Your portfolio’s sensitivity to market risk will predominately determine its return over time. And research suggests that investors are compensated for taking this risk over the long run.

  • Term: Term risk measures the risk an investor assumes by purchasing bonds on a maturity spectrum versus simply buying and rolling short-term debt. For assuming the risk of buying longer-term bonds, investors expect to receive a term premium.

These primary risk factors are common across investment portfolios and perform independently from each other (i.e., they are uncorrelated), which means combining them can result in powerful diversification.


Availability:

The diversification benefits of combining these primary risk factors are broadly available through traditional allocations to stocks and bonds and accessible through low-cost index funds.

Secondary Factors

While most investors own portfolios comprised largely of primary factors, capital markets can provide other sources of return. Prominent academics and practitioners have identified the below additional risk factors – considered secondary risk factors – that can provide a return premium over time.

  • Size factor: The size factor reflects research that indicates small-cap stocks outperform large -cap stocks. This risk premium is earned over time but is unpredictable in any given year.

  • Value factor: The value factor, simply stated, reflects that cheap stocks (“value stocks”) tend to outperform expensive stocks (“growth stocks”) over time. There is intuition around this secondary risk factor insofar as assigning a low valuation to a stock embeds an expectation that investors will earn a higher return to assume its risk.

  • Momentum factor: The momentum factor reflects elements of behavioral finance and measures the returns of recently high-performing stocks over the returns of recently low-performing stocks. It has been demonstrated by historical returns, which reveal that high performing stocks tend to stay high performing for a period and thereby offer a premium.

  • Gross profitability factor: The gross profitability factor can be defined in a number of ways but is primarily measured by the returns of stocks with high gross profits-to-assets over stocks with low gross profits-to-assets. It highlights that investors in highly profitable companies with capital discipline are rewarded over time.

These secondary risk factors can be important drivers of portfolio return, and when combined, represent a potentially potent source of diversification.


Availability:

Exposure to these factors is broadly available through traditional allocations to stocks but can be more directly owned through engineered beta strategies, which invest more intentionally in factors.

Alternative Risk Premiums

Although more narrowly available, alternative sources of return – called alternative risk premiums – are typical in structures such as hedge funds, which can take both long and short positions and/or use leverage.1 It’s important to note that not all hedge funds, or any one particular category of hedge funds, provide these return sources. Rather, they are found selectively at the strategy level, making manager and strategy due diligence particularly important.

  • Trend Following: Returns generated through strategies that combine long positions in up-trending markets and short positions in down-trending markets.

  • Carry: Returns generated through strategies that combine long positions in high-yielding assets and short positions in low-yielding assets.

  • Low Beta: Returns generated through strategies that combine leveraged long positions in assets with low market risk and short positions in assets with high market risk.

Alternative risk premiums have positive expected returns, are uncorrelated to stocks and bonds and therefore offer valuable diversification to stock and bond portfolios.


Availability:

This return source is less broadly accessible then primary and secondary risk factors and accessed primarily through alternative investment strategies, including hedge funds.

Illiquidity Premiums

The illiquidity premium refers to the excess return over the liquid public market, potentially generated by an investment that cannot easily be converted to cash for its fair market value. This return source is prevalent in private markets, which academic research suggests compensate investors for taking on illiquidity.


Availability:

These premiums are less common than other return sources but available – particularly to qualified investors 2 – through private equity investments.

Alpha

Alpha is at the top of the return source pyramid, given its relative scarcity. Alpha refers to the return of an investment generated by manager skill, such as successfully picking stocks that outperform or by timing the market. Another way to think of alpha is as the skill-based return left over after accounting for all of the above-mentioned risk factors. True alpha is rare and often negated by manager fees.


Availability:

Alpha is less common than all other return sources and available through a relatively small cohort of actively-managed investment strategies. Seeking true alpha requires rigorous performance evaluation to separate skill from risk or luck.

Putting it all together

Each portfolio is ultimately defined by its exposure to these five potential return sources. Work with your advisors to improve your portfolio potential by:

  1. Ensuring your portfolio is taking advantage of all available sources of return
  2. Finding the optimal mix of return sources given your unique life goals and/or desired risk level
  3. Getting what you pay for: Avoid paying high fees for exposures that are commonly available

The power of diversification is real. Make sure you are taking full advantage of it.

  1. The use of borrowing to fund an asset purchase, which increases potential returns but also increases potential losses.
  2. The information contained herein is for informational and educational purposes only. Past performance is not indicative of or a guarantee of future results, which will fluctuate as market and economic conditions change. Private assets are illiquid and are not suitable for all investors, and transferability may be limited or even prohibited.

Disclosures

This information is not intended to be and should not be treated as legal, investment, accounting or tax advice and is for informational purposes only. Readers, including professionals, should under no circumstances rely upon this information as a substitute for their own research or for obtaining specific legal, accounting or tax advice from their own counsel. All information discussed herein is current only as of the date appearing in this material and is subject to change at any time without notice.

The information contained herein, including any information regarding specific investment products or strategies, is provided for informational and/or illustrative purposes only, and is not intended to be and should not be construed as an offer, solicitation or recommendation with respect to any investment transaction, product or strategy. Past performance is no guarantee of future results. All material has been obtained from sources believed to be reliable, but its accuracy, completeness and interpretation cannot be guaranteed.