Did he just say that Diversification was broken?

We’ve been starting to see more and more of this lately…. People eschewing diversification for the big returns from being fully invested in the stock market. Add that to the questionable investments lately (Football player’s success) and the margin debt at the NYSE moving into bubble territory, and it’s starting to look a bit frothy out there.

But let’s tackle the diversification is broken theme for a minute, articulated in a recent piece by John Authers titled “This is no time to get off the equity train.” The first paragraph lays it out there quite clear (emphasis ours).

 “At present, stock markets continue to charge uphill. That is good for those who are on board, but horrible for anyone who has gone out of their way to diversify. Diversification looks bad when it turns out you don’t need it.”

That’s a harmless enough statement in and of itself. A lifejacket looks silly when you don’t need it. A seatbelt is a little uncomfortable when you don’t need it. And insurance is expensive when you don’t need it. We couldn’t agree more. But Mr. Auther’s starts to take it in a bit of a different direction as he goes on with his piece, calling out a poster child for portfolio diversification and the heavy use of alternative investments: Yale’s endowment:

Yale University’s endowment, under the leadership of David Swensen, upended conventional thinking on diversification some two decades ago. Mr Swensen argued that he was most likely to find value away from the public markets. Private markets were more likely to be inefficiently priced, and therefore offer bargains. He moved out of bonds and cash, and into hedge funds, private equity and real assets such as forestry. Yale now holds about 6 per cent of its assets in US equities. This reaped impressive returns for decades, and many endowments imitated it.

But this diversification could not stop Yale from suffering a loss during the financial crisis period of 2008-09. Since then, the stock market boom has not flattered endowments.”

The logic here that having as little as 6% in equities “reaped impressive returns for decades” but then suffered a loss during the 2008-2009 period is somehow a bad thing is missing the forest for the trees,  in our opinion.

Yale’s endowment reported a 4.5% return in 2008, and a -24.6% in 2009, but those are Fiscal Years, ending in June 30 of each year. So the -24.6% loss in Fiscal Year 2009 was actually between July 2008 and June 2009, which is nearly exactly the height of the financial crisis, where the S&P 500 was down -28.4% over that period. Not sure about you, Mr. Authers, but we would much rather have that -24.6% versus the -28.4%. Oh, and there’s the little point worth mentioning that the 2009 loss followed 19 consecutive years of gains (when the S&P 500 had six annual losses over the same period).

Yale Endowment Performance

Source: Yale Endowment
(Disclaimer: Past performance is not necessarily indicative of future results)

Next up, the argument that the traditional 60% stocks/40% bonds split is better than full diversification.

“Figures for 2011-12, when stocks also fared well, are drab. Yale made 4.7 per cent, but the average US endowment dropped 0.3 per cent, while the S&P gained 5.5 per cent. A combination of 60 per cent in stocks and 40 per cent in bonds, which is the way most endowments managed their money before the Yale revolution, would have risen 6.3 per cent.”

We wouldn’t recommend investors base decisions on a single year, ever. One year does not make a track record. And if we look at the ten years, from Jan 2003 to present, the Yale Endowment would have a 117% total return, versus a 60/40 portfolio having a total return of 57%, (we used the S&P 500 at 60% for stocks, and the Barclay Bond Aggregate index for bonds at 40%).

Yale vs. 60 40 (1)(Disclaimer: Past performance is not necessarily indicative of future results)
(Disclaimer: Yale Endowment does not include this year’s returns)

Again, not sure about you, Mr. Authers, but +117% versus +57% shows us that diversification into more than just bonds is working quite well for Yale – to the tune of twice as well over the last 10 years.  But that may be what Authers is really getting at, as his closing lines talk about Yale’s returns being more about Swensen being early to the alternatives/private equity movement, versus their benefit as diversifiers, and that he is reducing the private equity exposure because of that:

“Mr Swensen himself is reducing his allocation to private equity. Many of his buys were a one-off opportunity – to buy assets when they were not understood and when skilled managers were available to take advantage of mispricings. That opportunity no longer exists. As “me-too” investors crowded in, markets grew more efficient and returns dwindled – but the wave of imitators did help push up Yale’s performance.”

That argument is a little over our pay grade (and research budget) – not being private equity folks – but we can argue that it is unfair to implicate all of the alternatives space based on that same logic. And to be fair, Authers isn’t implicating all alternatives – he seems to be just calling out private equity here, saying the opportunity for private equity to managers to “take advantage of mispricings” no longer exists. (a big claim with the billions and billions of dollars current in Private Equity – but he’ll have to defend that on his own).

And Authers does save himself from jumping on the ‘diversification isn’t needed’ crazy train in his conclusion, saying:

That does not mean that the case for diversification has vanished. Conditions like those of the past five years are unlikely to be repeated very often. But the case is not to buy what Yale bought two or three decades ago. Rather, it is to apply the same process, look for assets that may be inefficiently priced and would not fall with equities, and to buy those.

That process should still work when, as is inevitable, stocks at last lose their momentum.”

We can argue on his semantics there, in that it is more important to find asset classes with different return drivers (which leads to them not falling with equities) rather than assets which are inefficiently priced, but that may be splitting hairs – and at the end of the day we’re thankful he realizes the inevitability of stocks, “at last” losing their momentum.


One comment

  1. Thanks for this interesting piece. Some brief points.

    I never at any point said that diversification was broken. It isn’t, and no such phrase appears anywhere in the piece. But the popular Yale model of diversification has been made to look very bad over the last five years. Over that period, certainly a short one for measuring an endowment, but still more than one year, it has fared much worse than the S&P. Perhaps more importantly, and it was a mistake not to emphasise this, most of the endowments that have tried to mimic it have done far worse still. A big part of the Yale success, in my opinion, is its first-mover advantage.

    Second, I did not write the headline (journalists never write their own headlines), and would certainly not have chosen it. I was attempting to write a piece about diversification, and certainly not trying to make a call on the equity market. One commenter on the original piece, perhaps led by the headline, said that it was always worrying when a long-term bear throws in the towel – I would admit that it’s probably fair to say that I’ve been a long-term bear during the relief rally since 2009.

    Third, you seem to have missed this sentence in the piece: “Investors should allocate money to different assets according to the risks they carry, so that not everything would fall if one risk comes to pass.”

    This is the way that diversification is moving, and it should do. No need to worry about semantics.

    I thought the point of my piece was that diversification was important, and that the last five years, when it turns out an investment in an S&P tracker fund would beat almost anything else, were an aberration. Never mind.

    If you want to get a fuller picture of what I’ve written about the Yale model, please take a look at the following links:



    Best wishes, and thanks for taking the trouble to write about my piece at such length,

    John Authers

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