Radical diversification, endowment-style investing and portfolio simplicity

26Oct07

The most common asset allocation approach presented to individual investors these days is one best described as ‘core and explore.’ At the core of a portfolio one would put broad-based, low-cost, indexed asset exposures. Think domestic and developed-market international stocks and domestic bonds. The explore part of the portfolio would include additional asset classes (emerging market equities, REITs, etc.) and more actively managed equity exposures.

However, the very public success of endowment-style investors has brought into question whether this approach is really the most appropriate. One can think of endowment-style investing as flipping this paradigm around. Now at the core of a portfolio one would put things like absolute return funds, private equity and real assets (real estate and commodities). One would complete the portfolio by adding traditional asset classes.

Barry Barnitz at Asset allocation points to a paper by P. Brett Hammond at TIAA-CREF Asset Management that explores this very topic. In “Reverse Asset Allocation: Alternatives At The Core” he looks at how one might structure an alternative asset-centric portfolio using traditional asset classes to control overall portfolio risk.

While examining how some of the best institutional investors allocate their portfolios is instructive, it also has some pitfalls. Indeed David Swensen, head of the Yale University endowment fund, wrote a book for individual investors he made portfolio recommendations that explicitly avoid alternative asset classes. His recommendations can be easily implemented with existing low-cost ETFs.

An alternative asset-centric approach is by necessity not a simple approach. The selection and monitoring of alternative assets, is by its nature an active one that requires additional time and resources. Christopher Davis at Morningstar.com has an article up that addresses the attraction of an endowment-style portfolio and draws some lessons from this approach. Davis acknowledges that individuals cannot really and truly emulate a Yale in that they have access to private investment funds that individuals do not. However individuals can use the endowment approach by taking to heart the twin lessons of diversification and discipline.

James B. Stewart at SmartMoney.com covers some of this same ground, but gives more individuals a better chance of being able to craft an endowment-like portfolio. Stewart correctly highlights the many differences between how an endowment can invest and how an individual can invest. The article emphasizes the twin notions of “true diversification” and the need to have a clear, well thought out, systematic portfolio approach. Stewart includes some neat graphics that document where Harvard and Yale’s funds invest and how one might apply this to an individual portfolio.

We tend to like the idea behind ‘radical diversification.’ Indeed we liked it so much we bought the domain name. Radical diversification requires additional research and is by no means guaranteed to provide either incremental returns or diversification. One common complaint is that once asset classes or investment strategies get packaged into tradeable vehicles like ETFs they become more correlated with the overall capital markets.

We have complained previously that fund sponsors have overreached in their desire to call new funds, ‘asset classes.’ New asset classes are few and far between. Most new funds are simply investment styles or approaches re-packaged for mass consumption. There is indeed little new under the sun.

So where does this leave us? Individuals cannot, nor probably should they, become endowment fund wannabes. There are simply too many barriers between what an individual and a long-lived institution can do. In our mind that leaves two different approaches.

One approach is that of portfolio simplicity or one might even call these “lazy portfolios.” This approach is one that requires less time and effort and relies on the performance of the capital markets to generate investment returns over time. Low expenses, broad diversification and discipline play a key role in this approach. The use of portfolio rebalancing is one of the unsung heroes in this approach in that it forces the investor to sell asset classes that outperformed and buy asset classes that have underperformed. Over time one might add additional asset classes over time as they become more seasoned and packaged in low-cost, user-friendly fashion.

The second approach is to take one a more active asset allocation. Using the endowment template one would reduce exposure to plain vanilla equities and fixed income asset classes and increase exposure to alternative investment vehicles that are attempting to add incremental investment performance, or alpha. Diversification is pursued in this approach more aggressively by seeking out less well-known corners of the capital markets.

Every investor is by definition different. But these different investment approaches have some things in common. These include:

  • The need for having a well thought out, systematic approach to asset allocation.
  • The importance of broad portfolio diversification.
  • Rebalance portfolios on a regular basis.
  • Avoiding unnecessary costs in areas where there are little opportunity to add value.

Investors would do well to keep these principles in mind. Even a simple or “lazy portfolio” approach is built upon complex investment theory. How you choose to apply these principles to your own portfolio is up to you.

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