I FIRST PRESENTED THE IDEAS CONTAINED IN THIS article
at an Institutional Investor conference in January.
Before taking the podium I struggled to come up with something
that would convey the importance of what was to follow. I
decided to inform this audience of professional pension fund
and endowment managers that their luck had run out:
They were going to learn about investing in risk, either from
me or from someone else, but not unlike having dinner
with the in-laws it was going to happen, so they would
be well served to get it over with. The doors were locked, the
audience lost hope, and we pushed forward.
For most of the audience, 2008 had been a shock,
characterized by a serious loss of self-esteem and
devastatingly poor performance that had been exacerbated by a
fundamental lack of risk diversification. But such an outcome
was not inevitable. In what follows I describe and substantiate
how, through the use of a novel, rational allocation process,
investors can achieve significant improvements in portfolio
diversification, thereby potentially increasing the return and
decreasing the risk of their portfolios.
Post-2008 most investment portfolios have remained one-trick
ponies, effectively possessing a single source of variance, a
typical proxy for risk. In the case of private investors, with
a standard 60-40 stock-bond portfolio, roughly 97
percent of the portfolios variance can be explained by
the equity allocation. Perhaps surprisingly, the typical U.S.
pension fund doesnt fare much better, despite a more
broadly diversified asset allocation, full-time investment
professionals and, in many cases, externally hired experts
variously referred to as guys from out of
town or guys with shiny shoes. Accordingly,
the typical U.S. pension fund has in excess of 90 percent of
its variance explained by a single risk factor.
There are three basic reasons for this. First, when the bulk
of an investment allocation is directed toward its most
volatile component, then the emergence of a single dominant
risk factor is a virtual certainty. Second, many investors
mistakenly assume that nominal, or apparent, diversification is
the same as real diversification. This is, of course, not true.
To understand why nominal is not real diversification, we must
pause for a moment to consider the three basic allocations in a
typical diversified institutional portfolio: equities, fixed
income and alternatives. With respect to the equity allocation,
when you own every stock on the planet, you have in effect
eliminated any sources of idiosyncratic risk and now own a
single, rarefied risk factor: systematic equity market