Diversification Done Right; A New Take on MPT

In between meetings, conference calls, and the FOMC announcement last week, I attended the NAAIM (National Association of Active Investment Managers) conference. I find it helpful every once in a while to step outside of my own little world of investment strategies and listen to what others have to say about the ways they go about skinning the cat (i.e. outperforming the markets and managing risk).

In looking over the agenda for the two-day meeting, my attention was drawn to a panel discussion on “Investment Process Do’s and Don’ts”. After managing “other people’s money” for nearly 25 years, I figured I had been exposed to most of the “don’ts” and I was intrigued by what this group had to say about the “do’s.”

The moderator of the discussion, whom I’ve gotten to know over the past month or so, is a self-proclaimed “quant” who depends entirely on mathematical models for all decisions. We’ve enjoyed a couple of energetic discussions about the merits and validity of incorporating some degree of “subjectivity” into the investment process. While I lean heavily on my models and will not ignore a signal, I will admit that I prefer to have the ability to say “hey, wait a second, this doesn’t make sense” on occasion when making decisions… And I most definitely want to be able to adjust my holdings to stay in tune with market leadership. But the bottom line is I’ve grown to respect Ted’s point of view and I was intrigued by what this panel would have to offer.

Although there were some interesting points made about some rather sophisticated topics, the one thing that really got my attention was rather simplistic: the subject of diversification. And I was surprised to hear my quant-buddy talking to a group of market geeks about something that some might deem an elementary subject.

Before your eyes glaze over and you move on to something else, please allow me another minute or two to make my point. You see, while diversification isn’t exactly a new concept, this different twist on the subject is worthy of your consideration. And I would highly recommend that each and every investor try to implement the theme about to be revealed into their own investment process.

Something New?

To most investors, the idea of diversification is not exactly new. The concept of owning stocks, bonds, REITs, etc. gained popularity in the late 1950’s when something called Modern Portfolio Theory (MPT) was introduced. According to Wikipedia

Unfortunately, the concept of diversification has fallen down in real-time recently. Investors have learned the hard way that when the correlation of asset classes moves toward one, diversification provides little protection. For example, during the “Crash of ‘87” it didn’t matter what you owned – stocks, bonds, gold, REITs, etc. – everything went down. And since I lived through the crash “live,” this was a lesson I have never forgotten.

But with the mutual fund industry preaching buy-and-hold and diversification (and proven correct during secular bull market periods), the majority of investors assumed the lesson of what happens to asset classes during periods of “high correlations” wasn’t needed. Until it was, of course.

The Credit Crisis Bear Market (as I like to call the period from late 2007 through March 9, 2009) brought this lesson back to light in a BIG way. In short, when investors fear for their financial lives and systemic risk rears its ugly head, it doesn’t matter what you own; it’s going down.

The King is Dead; Long Live the King

To many, 2008 is now viewed as the period where buy-and-hold and traditional asset allocation came to die. (Yes fans, even gold fell nearly -30% from top to bottom during 2008.) But as the saying goes, “The King is dead… Long live the King.” So, with the king of investment strategies – Buy and Hold – no longer alive and well, it appears that active management of the markets is the new “king” of the investment world.

But, as anyone who has employed active management strategies knows, an active approach isn’t a panacea either. For example, risk managers have a tendency to underperform during up markets (especially the first year of a new bull market). Trend-following systems perform well during some environments and then miserably in others. The same can be said for mean-reversion strategies, stock picking, sector rotation, and so on, and so on.

A Different Way to Diversify

Which bring me to Mr. Lundgren’s point. Ted wasn’t talking about diversification by style, cap size, sector, or even asset class. Nope, the key to the discussion was that it is important to diversify investment “strategy.”

Ted, who happens to run some very active programs at Hg Capital Advisors, even went so far as to say “Buy and hold isn’t a bad strategy – at times.” But his key point was that if you want to build a TRULY diversified portfolio, you need to include a multitude of investment strategies.

As I reviewed the notes from the panel, I came to a pleasing revelation. It turns out that I utilize this very approach at my firm and in my own personal portfolio. Imagine my surprise when it dawned on me that I was “accidentally” doing something right. (Maybe all those years in this business haven’t been for naught after all!)

For example, in my own personal portfolio, I employ three distinctly different strategies. For one-third of my portfolio, I use what we call the “TopStock” strategy to trade individual stocks. Then for another third, I utilize a “market timing” system that moves in and out of the U.S. market indices via a long-short-neutral approach. And finally, I include a “go anywhere” global ETF strategy that is momentum based.

From my perspective, I have an equity management strategy (with risk management systems built in), a “timing” strategy that can “go both ways,” and a global “go anywhere” momentum strategy with no pre-set allocation or commitments to those silly style boxes. Thus, my thinking is that with this mix of strategies I should (a key word – remember, there are NEVER any guarantees in this business) be able to find a way to make some money in most environments.

The last part of that sentence is key. It is important to recognize that diversification is designed to “smooth out” your returns. This means that your portfolio won’t benefit as much as it potentially could when one of your strategies in “on a roll.” And then there is