Even Bad Diversification Works

Last week, Business Insider unveiled the “Most Important Charts in the World.” If ever there was an outfit with a flair for the dramatic headline, that would be them…but there was one chart that caught our attention entitled, “Diversification Works.” It was from none other than Josh Brown at Ritholtz Wealth Management.

Diversification Works

(Disclaimer: Past performance is not necessarily indicative of future results)
Chart Courtesy: The Reformed Broker

Now if you asked a roomful of random investors what diversification in their portfolio meant to them, chances are all of them would have a slightly different answer. In this particular instance, Brown defines diversification as a portfolio including a 30% allocation to the S&P 500, 30% to foreign stocks, and 40% to bonds. We’ll give you the bonds, but pairing foreign stocks with US stocks doesn’t strike us as all that diversified. Foreign stocks (MSCI ex US) have a correlation of 0.89 with US stocks over the past 10 years. [Tweet “”Foreign stocks (MSCI ex US) have a correlation of 0.89 with US stocks over the past 10 years.””]

And being managed futures folks, we couldn’t help but look at their chart and wonder… what if you had managed futures in the foreign stocks slot instead? Would diversification have “worked” then?

Here’s our chart swapping the 30% foreign stocks allocation with 30% managed futures, per the Newedge CTA Index.

Diversified with Managed Futures

(Disclaimer: Past performance is not necessarily indicative of future results)
(Diversified = 40% Barclays Bond Aggregate Index, 30%  Newedge CTA Index, and 30% SPY)

While Brown was bragging of the diversified portfolio regaining its peak 14 months before a stock-only portfolio, the portfolio containing managed futures regained its peak 35 months prior, or more than twice as fast!  How? Because 30% of the portfolio was positive during the 2008 crisis as managed futures became negatively correlated to stocks during the crisis.  Now that’s some diversification.

Some may concentrate on the far right hand side of both of these charts, where the stock-only portfolio has, after 7 years, eclipsed the total return of the diversified portfolio (whether diversified in other stocks or managed futures), and discount diversification as unimportant or even costly. You would have made more money not being diversified, but that’s not the point for those who want some protection.

The point, as Josh Brown points out, is to have shorter drawdowns. The point is to be able to regain a peak sooner. The point is to be able to not panic at the bottom.  And, of course, the point (for us) is that diversification can “work” even better when you aren’t diversifying with another form of stock market investment (foreign stocks), and instead gaining true diversification with different return drivers.

P.S. – Past Performance is Not Necessarily Indicative of Future Results. The chart should probably be titled – Diversification Worked (past tense), not works (present tense). We noticed a comment summing that up rather nicely, and ask the simple question: Will Simple Beat Complex in the Next 5 Years?

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Disclaimer
The performance data displayed herein is compiled from various sources, including BarclayHedge, and reports directly from the advisors. These performance figures should not be relied on independent of the individual advisor's disclosure document, which has important information regarding the method of calculation used, whether or not the performance includes proprietary results, and other important footnotes on the advisor's track record.

Benchmark index performance is for the constituents of that index only, and does not represent the entire universe of possible investments within that asset class. And further, that there can be limitations and biases to indices such as survivorship, self reporting, and instant history.

Managed futures accounts can subject to substantial charges for management and advisory fees. The numbers within this website include all such fees, but it may be necessary for those accounts that are subject to these charges to make substantial trading profits in the future to avoid depletion or exhaustion of their assets.

Investors interested in investing with a managed futures program (excepting those programs which are offered exclusively to qualified eligible persons as that term is defined by CFTC regulation 4.7) will be required to receive and sign off on a disclosure document in compliance with certain CFT rules The disclosure documents contains a complete description of the principal risk factors and each fee to be charged to your account by the CTA, as well as the composite performance of accounts under the CTA's management over at least the most recent five years. Investor interested in investing in any of the programs on this website are urged to carefully read these disclosure documents, including, but not limited to the performance information, before investing in any such programs.

Those investors who are qualified eligible persons as that term is defined by CFTC regulation 4.7 and interested in investing in a program exempt from having to provide a disclosure document and considered by the regulations to be sophisticated enough to understand the risks and be able to interpret the accuracy and completeness of any performance information on their own.

RCM receives a portion of the commodity brokerage commissions you pay in connection with your futures trading and/or a portion of the interest income (if any) earned on an account's assets. The listed manager may also pay RCM a portion of the fees they receive from accounts introduced to them by RCM.

See the full terms of use and risk disclaimer here.

Disclaimer
The performance data displayed herein is compiled from various sources, including BarclayHedge, and reports directly from the advisors. These performance figures should not be relied on independent of the individual advisor's disclosure document, which has important information regarding the method of calculation used, whether or not the performance includes proprietary results, and other important footnotes on the advisor's track record.

Benchmark index performance is for the constituents of that index only, and does not represent the entire universe of possible investments within that asset class. And further, that there can be limitations and biases to indices such as survivorship, self reporting, and instant history.

Managed futures accounts can subject to substantial charges for management and advisory fees. The numbers within this website include all such fees, but it may be necessary for those accounts that are subject to these charges to make substantial trading profits in the future to avoid depletion or exhaustion of their assets.

Investors interested in investing with a managed futures program (excepting those programs which are offered exclusively to qualified eligible persons as that term is defined by CFTC regulation 4.7) will be required to receive and sign off on a disclosure document in compliance with certain CFT rules The disclosure documents contains a complete description of the principal risk factors and each fee to be charged to your account by the CTA, as well as the composite performance of accounts under the CTA's management over at least the most recent five years. Investor interested in investing in any of the programs on this website are urged to carefully read these disclosure documents, including, but not limited to the performance information, before investing in any such programs.

Those investors who are qualified eligible persons as that term is defined by CFTC regulation 4.7 and interested in investing in a program exempt from having to provide a disclosure document and considered by the regulations to be sophisticated enough to understand the risks and be able to interpret the accuracy and completeness of any performance information on their own.

RCM receives a portion of the commodity brokerage commissions you pay in connection with your futures trading and/or a portion of the interest income (if any) earned on an account's assets. The listed manager may also pay RCM a portion of the fees they receive from accounts introduced to them by RCM.

See the full terms of use and risk disclaimer here.

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