This article was first published in the Institutional Investor on 6 February 2023 here.
Investors struggle with diversification, and it’s logical to wonder why it’s such a difficult goal to achieve. The hard truth, however, is that investment decision makers are compelled to chase short-term performance because it’s the measuring stick for how they themselves are judged. In recent years, that has led to investors piling into alternatives – to the point that from one perspective, alts are akin to very expensive beta.
“The thing investors are trying to diversify – equities – have generally done well since the 2008 global financial crisis,” says Phil Seager, head of absolute return at CFM. “The pressure is on to produce results year after year, and the penalties – career risks – for not beating the equities benchmark outweigh the incentives for beating it. If you diversify and equities remain on a tear, nobody will thank you for it.”
In Seager’s experience, investors want a diversifier to go up when the market is down and go up when the market is up.
“But that is not decorrelation,” he says. “It’s wishful thinking and a misunderstanding of decorrelation. Being down when market is down will happen. In a world of short time horizons driven by noise and luck, you must look at the long term to see meaningful results.”
Lack of discipline
The longer a drawdown of public markets stretches, the more likely there will be an accompanying markdown of assets in private markets. An increase in correlation of public and private assets can only occur over long timescales due to lack of liquidity – and that’s what investors are experiencing at the moment.
When equities go up over a long period of time (as they have) a leveraged version goes up even more – but that does not make it a genuine diversifier.
“Private equity gives a false sense of comfort that all is well, and investors seem happy to pay for the privilege,” says Seager. “That’s what happens when you add up leveraged risk-premia, some factor exposure, some liquidity premium – it creates a deluded notion that there is less volatility [in private markets].
The scenario described by Seager leads to lapses in discipline that can permeate the investment process from top to bottom. Trend following, a strategy in which CFM ranks among the pioneering innovators and practitioners, is driven by the market force of performance chasers – and even it is not immune from investors attempting (and failing) to use it as a strategy for chasing performance.
“Investors chase returns, and that creates trends – some investors even trend on trend followers,” says Seager. “But trend following is a fat right-tailed strategy with persistent periods of poor performance and infrequent accelerations. It is very difficult to performance chase because in attempting to do so you’ll typically buy high and redeem before the acceleration. That lack of discipline can be costly.”
Building true diversification
A typical institutional portfolio these days is a mashup of public equities in the U.S. and internationally, private equity, fixed income, real estate, and hedge funds. Each of those components has exposure to equities – private equity is a leveraged version of equity, so it has equity premium in it; hedge fund indices are made up mainly of equity long-shorts, with equity premium; fixed income indices like the Global Agg include corporate credit, and that has equity risk premium in it; and REITs have equity risk premia, too.
“Many investors think they’re diversifying, but they’re actually just loading up on more equity exposure,” says Seager. “True diversification can only come from shorting.”
Seager suggests looking at an institutional portfolio through the lens of principal component analysis (PCA), which identifies the riskiest portfolio and projects it out, then continually repeats with the next riskiest, simplifying high-dimensional data into fewer dimensions that act as summaries of patterns.
“Investors are most acquainted with PCA through the stock market, and accustomed to the idea that the first principal component is the market itself. The first PC carries about half of the total variance,” says Seager. “An equal weighting across stocks has risk loading mostly on this first PC, the market itself – that’s not very diversified.”
Start to add asset classes, i.e., bonds, FX, commodities, and if the first PCA was long everywhere but bonds, it’s now long across the board as bonds and equities have gone from anti-correlated to correlated – there is now even less diversification in a long-only scenario than before.
“You have to go equity market neutral in stocks, or long/short in asset classes to achieve genuine, uncorrelated diversification,” say Seager.
It’s one thing to achieve decorrelation – but what about alpha? After all, outperformance is necessary at some point.
“The current environment is very diverse across geographies – from the tightening of the Fed to ongoing QE and yield curve control in Japan,” says Seager. “A combination of non-policymaker driven volatility and high geographical dispersion should be good for macro plays. The QE environment of the past has been driven by big moves in markets driven by policy announcements. At CFM, we like volatility, but prefer if it originates from markets rather than fickle policymakers. Assuming healthy volatility going forward, investments with Commodity Trading Advisors (CTAs), macro traders, trend followers, and market neutral equity players could provide decorrelation and the resultant returns investors hope for when they think about diversification.”
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