Is diversification your friend?

Diversification: does it really protect your money when you need it the most?

If I am writing this article, it is because the short answer is: not quite, but…
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Let’s start explaining the concept of diversification and why we need it. Diversify your portfolio means to take uncorrelated assets and combine them together in such a way to be protected from excess drawdowns during equity market downturn while generating alpha in the long run. Typical long term uncorrelated assets from the S&P500 (SPY) are: emerging market equities (EEM), gold (GLD), bonds (TLT), agricultural commodities (DBA), energy (XLE),… There are several techniques to select the appropriate allocation; one of the simplest way to do it is the Risk Parity methodology.

In theory this approach makes sense but what we must keep in mind is that the financial market is a very dynamic environment. As the chart below shows, the correlation coefficient (between different asset classes and the S&P500 dynamically calculated over a period of one month) substantially changes with the volatility of the market (VIX). In periods of lower volatility, the asset classes are somewhat uncorrelated from one another. When the volatility starts to spike (often associated with sudden pullback of the equity market), then most of the assets start to move in the same direction of the market (positive correlation). The only exceptions are: treasury bonds that move in the opposite direction (negative correlation) while gold is somewhat all over the place.

What does that mean for the portfolio? Let’s say that the portfolio is statically diversified over the six different asset classes, as soon as the volatility starts to spike (market moving down), five assets out of six will also move down thus limiting the downside protection risk. The only savior is treasury bonds.

​If bonds are the only way to protect the portfolio when the market goes south, while keeping in mind that over the long run equities have the best return, then diversification can be heavily simplified by investing solely in equities and bonds. 

There is a “but” to this: the splicing of the portfolio must be dynamic. In particular:

• If bonds and equities are positively correlated (low volatility periods) then let’s invest only in equities
• If bonds and equities are negatively correlated then let the portfolio allocation being proportional to this correlation

Moreover, if the profits should be maximized as much as possible:

• Let’s not invest in equities if the volatility is above 40% (usually SPY has negative returns above this value)
• Let’s not invest in bond if the volatility is below 14% (usually TLT has poor performances when the market volatility is below this value)

Putting all this knowledge / steps together, we then get the dark blue time series. The light blue being the risk parity approach to the six different asset classes while the gray line is the benchmark.

Compared to the benchmark, dynamically diversifying between equities and bonds allows: increase the overall return by 26% while reducing the max drawdown from 56 to 15%. Dynamic diversification of truly uncorrelated assets creates the real hedge against market downturns. The risk parity methodology applied to the six statically uncorrelated asset classes would have resulted in 12% lower return than the benchmark and 33% maximum drawdown.

I hope you enjoy reading it and find the content useful.

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