Benchmarking and radical diversification

28Jul06

One portfolio management approach to the increasingly complex capital markets is to diversify as widely as possible across asset classes and strategies. This is sometimes called “radical diversification.” While theoretically sound it does pose one dilemma for investors: benchmarking.

While the goal of radical diversification is to generate more consistent, less volatile, real returns it also makes benchmarking all of the various moving parts of a portfolio all the more difficult. While benchmarking may be a bit of yawner to many, it is an essential part of any portfolio review process.

Once you move beyond generic market-based index funds, one needs to benchmark. Whether one has outside managers, like actively management mutual funds or hedge funds, or manages your own portfolio of individual securities, comparing those results to an appropriate benchmark is important. In short, ignorance of the appropriate benchmark is not an excuse.

This came to mind when we read a piece by Shefali Anand in the Wall Street Journal discussing the performance to-date of the long-short category of open-end mutual funds. In this new category of “hybrid funds” there is a broad range of strategies including their exposure to the stock market. It is therefore important for investors to realize what strategy their manager has undertaken, but also to compare it to the correct (often custom) benchmark.

Perhaps not surprisingly, long-short funds do better than their market-neutral rivals when the market is rising — after all, the majority of their holdings are in traditional stock investments. But in down markets, “I wouldn’t expect these funds to always gain ground,” says Morningstar analyst Dan McNeela.

By contrast, market-neutral funds are more likely to hold up better in down markets, because they have pretty much hedged all their bets.

In a theoretical sense we should be comparing the marginal return of any asset in our portfolio to the marginal risk it generates. That is a non-trivial problem and for individual investors there is little in the way of user-friendly tools that will allow us to measure this trade-off.

Unfortunately the major media has a tendency to compare everything to an obvious benchmark like the S&P 500. The best analogy we can think of is that of an automobiles. Most cars today are designed to go a pretty wide range of speeds safely. However we do not drive 55 mph on every road and under every condition. Sometimes 20 mph is appropriate, like in a school zone, whereas 75 mph (and up) is appropriate on flat, rural low-density interstates. Clearly one size does not fit all.

The same is true with investment benchmarks.  This story of course gets more complicated once we begin to include international investments. That is a story for another day however. Broad diversification, while a useful strategy, also comes with attendant costs. These include complexity and higher monitoring costs. By and large they are worth it, but there are few shortcuts.

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