Diversification still works—but to be effective it may require a thoughtful, informed approach beyond the abilities of most investors, according to a Morningstar conference panel.
Despite warnings of increasing correlations between asset classes, there’s still value in spreading bets within an investment portfolio so that clients might enjoy a smoother ride, said a panel of asset allocators on Tuesday at the Morningstar Investment Conference in Chicago.
“In almost every period, diversification works and works brilliantly,” said Brad Vogt, portfolio manager at American Funds and the principal investment officer for the firm’s Target Date Retirement Series. “It’s just a matter of timeframe and time scales.”
The 2008 global financial crisis, which saw increased correlations between asset classes like equities and fixed incomes as markets plummeted, has led some investors to question the value and efficacy of holding a broadly diversified portfolio.
Anne Lester, head of U.S. retirement solutions for global asset management solutions at J.P. Morgan Asset Management, noted that the rise in correlations, like the correction, was short lived.
“Even those portfolios which took it on the chin in 2008, if you didn’t sell those balanced portfolios where diversification didn’t work, most of them rolled right back in 2009 and 2010,” said Lester. “By 2011, you were OK. Ideally, you should be interested in time horizons more than three years. If you had held your course, you would have seen diversification work, it just didn’t work in a narrow timeframe.”
Investors who were quick to pull money out of certain asset classes not directly impacted by the underlying cause of the financial crisis—the bursting of the housing bubble combined with the proliferation of mortgage-backed securities and their derivatives—may have confused risk and volatility, said Bob Boyda, co-head of global asset allocation at John Hancock Asset Management. Falling confidence in managers exacerbated the crisis.
“We need to know the difference between volatility and impairment of capital,” said Boyda. “For example, if I have an investment-grade bond fund and I’m sure the managers are in it for safety, I don’t mind temporarily that it gets marked down amidst a crisis because that’s an opportunity for me as an investor. That’s an extreme example.”
Lester said that asset managers' views on diversification have increased in sophistication since 2008, as have the tools by which they measure risks and correlations within portfolios.
For example. having better knowledge of the multiple factors driving returns in an asset class allows managers to better address overlapping sources of risk and return, said Boyda.