Diversification and dynamism

10Feb09

In our earlier post we noted the tough task facing many investors as they face up to an investment world turned upside down.

Two words (or themes) we have touched on from time to time in this space spring to mind:  diversification and dynamism.  Quaint as it may seem the first is diversification.  Diversification is a age-old approach to portfolio construction, 2008 was unusual in that so many asset classes performed so poorly.  But a broadly diversified portfolio in 2008 would have had some exposure to foreign and domestic bonds that served as a counterweight to  other risky asset classes.

For some investors diversification is an anathema.  It will at times lead to lower overall portfolio returns.  However in times of stress an allocation to relatively safe assets can offset the challenges of risky assets.  The fact of the matter is that there is a whole host of ways to diversify.  Mohamed El-Erian makes the point that asset allocation needs to be far more pragmatic and dynamic in the coming years.  Opportunities are going to arise that simply weren’t a part of traditional asset allocation plans even a year or two ago.  The challenge is trying to capture different sources of return without unknowingly layering on too much correlated risk.

Only by embracing some level of dynamism can investors hope to profit from the rapidly changing investment landscape.  On one level, dynamism may simply mean portfolio rebalancing.  That is taking advantage of market movements to recalibrate a portfolio by selling assets that have appreciated to purchase assets that have declined.   In another sense it means a more active approach to investing.

Fortunately for investors the entire world of ETFs has opened up a range of opportunities for investors that did not exist even a few years ago.  The breadth of asset classes, sectors and strategies available is breathtaking.   Costs continue to come down so much so that a broadly diversified global ETF portfolio can be constructed for less than 15 bp a year.  In a low return environment keeping costs, both expenses and commissions, as low as possible is an effective way to boost returns.

That being said, the ETF industry was a tad overambitious in creating new funds and any number of them could very well go by the wayside.  Investors should heed the risk of orphan ETFs.  Nor should they invest simply in someting just because an ETF has been created.

For many investors stopping right here is in fact the appropriate thing to do.   However for more ambitious investors there are a number of ways to approach a dynamic strategy.  For instance using a simple tactical asset allocation model that invests only in those asset classes that are demonstrating strength.  One can even think of these dynamic strategies as an asset class with a very different return profile than the underlying.

This approach is a subset of the broader investment theme of momentum.  Momentum strategies are uniquely available to individual investors because they do not require a time consuming, fundamental approach to bottoms-up securities selection.  Again, the caveat being that investors need to be aware of the risks of piling on correlated risks.

To take things even further one could be embrace a a more dynamic research program that “adapts” to market conditions.  That necessarily involves more work , but potentially avoid the pitfalls of traditional momentum strategies.  See the MarketSci Blog for this approach in action.

No one should mistake dynamism for anything other than active investing.  It attempts to generate risk-adjusted returns above and beyond that for the market as a whole.  With that comes the risk of underperformance.  However, in an age of unprecedented investment volatility, opportunities will continue to present themselves whether you trade them or not..

Being an investor today requires a level of fortitude not seen in previous decades.   As traditional sources of investment advice fall by the wayside it may seem like we are alone.  In actuality the blogosphere has opened up a wide range of voices and strategies that were simply unheard a few years ago.  Some of them are useful, others not so much.  In all likelihood there is a group of like-minded investors out there, one need only seek them out.

This post is at best a cursory glance at the investment scene.  However the themes of diversification and dynamism provide a blueprint on how to approach the depths of the investment blogosphere.  There is plenty out there on the two subjects, one need only open your browser.  Armed with this knowledge, investors can build a foward looking investment process of their very own built to withstand the tough times we are facing.

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