Radical diversification and the 200 day moving average

23Apr08

One of the long-running themes of this blog has been an interest in wide-ranging portfolio diversification. One could even say we have an overriding interest in ‘radical diversification.’ It is a well-worn cliché in the investment world that portfolio diversification is one of the few ‘free lunches’ available to investors. While tired, we do believe that contention to be true.

The question for investors is to how to go about implementing diversification steps. One well-established track is to find new (and emerging) asset classes. Commodities have been one obvious example of late of a portfolio diversifier paying off for investors. Another example, is the so-called frontier emerging markets. These are emerging equity markets that have not yet established themselves in the eyes of the index providers. It is inevitable that we will see some sort of frontier market ETF trading sooner or later.

There are of course limits to the search for natural asset classes. The next step is to investigate investment strategies that have the ability to generate non-correlated returns. This can occur through a dynamic trading process or through the introduction of optionality. For instance the growing list of buy-write products create a unique return distribution through the sale of call options against underlying index positions.

Another notable example is hedge funds. One of the key reasons behind the rise of the hedge fund has been the claim that they generate returns uncorrelated with major asset classes. (As assets have flowed into hedge funds there is a belief that they are becoming more correlated, but that is neither here nor there.) While individual investors do have some limited access to hedge fund-like strategies, i.e. long-short equity, by and large individual investors are by and large shut out from the hedge fund world.

Where does that leave the individual investor seeking additional portfolio diversifiers? A recent post by Roger Nusbaum at Random Roger’s Big Picture highlights a way individual investors can go about investigating strategies that generate non-correlated returns. Roger looks at different ways an investor might take defensive action when the stock market dips below its 200 day moving average. For example a shift into the Swiss franc has proven a haven against equity market drops historically.

This sort of approach has also been extensively chronicled by Mebane Faber at World Beta. Faber notes in a recent post looks at different ways one might utilize his cross-market momentum model. Depending on one’s risk tolerance, there any number of ways of applying this technique across asset classes or even equity sectors. There are no guarantees this sort of approach will outperform over time. However, one can say with some confidence that it will not be particularly correlated with the overall market.

The bottom line for individual investors that there are approaches outside of traditional asset allocation that have the potential to provide portfolio diversification. These do-it-yourself sort of approaches do require additional time, research and risk. There is nothing wrong with adding additional asset classes, like commodities or frontier market equities in limited doses. One could even make the case for buy-write or long-short strategies. However, for the dedicated (and curious) investor dynamic asset allocation strategies can also be an additional tool in one’s diversification toolbox.

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