The challenge of naive diversification

07Jul08

In a bull market the concept of diversification seems hopelessly out-of-date. The benefits of concentration seem obvious. Ask anyone in 1999 about the case for Internet stocks. However during a market downturn the benefits of diversification rise to the forefront.

If it were only that easy. Diversification needs to be as well thought out a process as any other in portfolio management. This is due to the fact that the benefits of naive diversification seem to be more limited now that in the past.

Stan Luxenberg at TheStreet.com has an article on the results of an Ibbotson Associates study on diversification. The results show how the correlation between domestic and international stocks has increased over time. In addition, during periods of market stress those correlations tend to rise as well. Even hedge funds did not provide much diversification benefits. However bonds and commodities are still unambiguous portfolio diversifiers.

Paul Kedrosky at Infectious Greed notes how the popularity of commodity investing has risen with the institutional investing crowd. The challenge, he notes, is that these copycat investors are late to the party and are not exactly proceeding in the most “nuanced” fashion.

(As an aside the same could very well be said about investors in timber as an asset class as well.)

Just like commodities, hedge funds have become very popular diversifiers for many classes of investors. One could as the question whether investors are getting what they pay for with hedge funds. Rob Arnott and John West writing at IndexUniverse.com on how one might construct a portfolio with liquid asset classes that has all the beneficial aspects of hedge funds without all the costs and restrictions. In conclusion they write:

To be sure, a dedicated hedge fund allocation certainly has a place in many portfolios. The sizable fee drag and mediocre results of hedge funds, however, suggest that most investors will be better served by broadening their exposure to liquid asset classes before wandering down the hedge fund path.

The lesson from these articles is that naive diversification is no longer the panacea it once was. While individual investors should avail themselves of new diversification opportunities, they need to be mindful of the potential downside of new asset classes. In short, just because an oppotunity screams “diversifier” does not mean it is a no-brainer investment. Research, as always, remains of paramount importance.