Diversification is not a free lunch

Diversification is not a free lunch

Donald Pepper

Co-CEO & Head of Multi-Strategy

Donald Pepper

Co-CEO & Head of Multi-Strategy
Donald joined Trium Capital as Co-CEO in 2017. He took on the role of Head of Multi-Strategy in October 2024, having been on the Multi-Strategy Investment Committee for several years prior to this. He began his career at Goldman Sachs in 1987 in Fixed Income. In 2000, he started to focus on Hedge Funds in Prime Brokerage at Goldman Sachs and Merrill Lynch, where he was Managing Director of Prime Brokerage in EMEA until 2008, when he moved to become Head of Hedge Funds at New Star Asset Management and Henderson Global Investors, His responsibilities included being Co-Portfolio Manager of two Multi-Strategy Hedge Funds. In 2010, Donald moved to TT International as Investment Director before joining Old Mutual Global Investors in 2012 as Managing Director of Alternatives, where he was a member of the Quarterly Investment Committee and the Style Premia Investment Committee. Donald read Philosophy, Politics & Economics at The Queen’s College, Oxford, where he received an MA. He is a CFA Charterholder and holds the CFA Certificate in ESG Investing.
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Warren Buffett, one of the greatest investors of our lifetime, once said, “Diversification is a protection against ignorance.” Diversification among financial assets or investment strategies is designed to mitigate investor portfolio losses. The simplest form of diversification, advised by many wealth managers and financial planners, is the 60/40 balanced portfolio. A 60% allocation to equities is used for long-term capital appreciation, and the remaining 40% used to purchase bonds that will earn continuous income for investors.  

The central assumption behind the 60/40 portfolio is based on modern portfolio theory. The alleged diversification should protect the portfolio when concerns over economic growth arise. The premise is that equities will underperform due to lower earnings, and bonds will rally as central banks will lower rates to stimulate economic growth. Therefore, bonds act as a buffer as yields drop and prices rise. An investor holding a passive 60/40 portfolio since 1980 will have reaped a compelling annualised return of 8% and beat average inflation by five percentage points over that period.  

Source: Source: Bloomberg, Trium. Data from January 1980 to August 2024. Inflation data is as of July 2024. Equities = MSCI World TR / Bonds = Bloomberg US Treasury Total Return Unhedged USD Index (LUATTRUU).

Theory ≠ Practice

“In theory, there is no difference between theory and practice – in practice, there is.” – Yogi Berra (ex-baseball manager)

In theory, earning a real return of 5% appears to be an excellent proposition and long-term investors should pay attention to modern portfolio theory and hold 60/40 portfolios. Unfortunately, investors rarely have 40-year horizons. Data suggests that holding periods for equity investors average around 5.5 months, down from a 5-year horizon in the 70s. 

Source: IMF, Trium. Calculated as the NYSE and NASDAQ market capitalisation divided by total turnover value.
 

If investor holding periods are that short, has the 60/40 portfolio met their needs the past few years in a rising inflation environment? The results suggest that a passive allocation has not, delivering just 5% annually.

Source: Bloomberg, Trium. Data from January 2021 to August 2024. Inflation data is as of July 2024. Equities = MSCI World TR / Bonds = Bloomberg US Treasury Total Return Unhedged USD Index (LUATTRUU)..
 

The two culprits behind the negative real return are (i) the underperformance of the fixed income component as central banks hiked rates to tame inflation and (ii) the self-made invalid assumption that correlations are stable over time. Rolling correlation data shows that equities and fixed income have moved together often in recent years. . 

Source: Bloomberg, Trium. Data from January 1976 to August 2024 Equities = MSCI World TR / Bonds = Bloomberg US Treasury Total Return Unhedged USD Index (LUATTRUU)..

 

Passive investment diversification has not always been a free lunch. Fixed income and equities are only negatively correlated when core inflation is well below 2.5%. 

Source: Bloomberg, Trium. Data from November 1982 to July 2024. Equities = MSCI World TR / Bonds = Bloomberg US Treasury Total Return Unhedged USD Index (LUATTRUU).

More of the same

The lack of diversification has not been exclusive to bonds and equities in recent times. Below are rolling 3-year correlations of REITS and listed PE firms to a 60/40 portfolio. 

Source: Bloomberg, Trium. Data from December 2002 to August 2024. Equities = MSCI World TR / Bonds = Bloomberg US Treasury Total Return Unhedged USD Index (LUATTRUU) / REITS = MSCI World RETIRs Index / PE Firms = S&P Listed Private Equity Index.

Is there relief for passive investors?

“In order to be irreplaceable, one must always be different.” – Coco Chanel

One type of investment has proven to be very different to a 60/40 portfolio. The investment objective of a Multi-Strategy hedge fund is to deliver uncorrelated positive returns consistently over time. Multi-Strategy hedge funds combine market-neutral, event-driven and relative value strategies into a single portfolio to deliver idiosyncratic returns uncorrelated to the direction of markets. Diversification is at the heart of the portfolio, combining uncorrelated return streams to provide investors with steady returns over time.

Source: Bloomberg, Trium. Data from December 1999 to August 2024. Equities = MSCI World TR / Bonds = Bloomberg US Treasury Total Return Unhedged USD Index (LUATTRUU).
 

Modern Portfolio Theory suggests that for a given level of expected return, investors will always prefer the less risky allocation. In that case, as this chart shows, a 60/40 investor should consider Multi-Strategy hedge funds as part of their allocation.

Source: Bloomberg, Trium. Data from January 2000 to August 2024. Equities = MSCI World TR / Bonds = Bloomberg US Treasury Total Return Unhedged USD Index (LUATTRUU) / Multi Strategy Hedge Funds = Eurehakedge Multi-Strategy Hedge Fund Index.
 

And below since January 2021.

Source: Bloomberg, Trium. Data from January 2021 to August 2024. Equities = MSCI World TR / Bonds = Bloomberg US Treasury Total Return Unhedged USD Index (LUATTRUU) / Multi Strategy Hedge Funds = Eurehakedge Multi-Strategy Hedge Fund Index.
 

Unlike a passive 60/40 allocation, where the investor is unwilfully subjected to different correlation regimes and does not receive a diversification benefit when it is needed, active management of correlations is necessary to ensure diversification. This is made possible in a Multi-Strategy hedge fund because of real-time transparency. Multi-Strategy managers can view how individual underlying strategies perform in different market conditions and witness the real-time co-movements between capital sleeves, which act as helpful inputs into allocation decisions. In Coco Chanel’s words, Multi-Strategy hedge funds are different. 

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