Tuesday, January 30, 2024

When Diversification Isn't Diversification

Today I had a chance to look at some of the Blackrock models. I am not going to share details of their work but I do have a couple of high level observations one thing to watch out for. Blackrock is a client holding.

To their credit, they don't use their funds (iShares ETFs and Blackrock mutual funds) exclusively, there are funds from other providers sprinkled in. In models that use alts, the allocations to alts have some pretty big weightings to some funds, 20-30% in some instances but in models with that much in single alts, they do say that their alt portfolio should be used along side a more typical equity and fixed income portfolio. 

For alts they seem to favor market neutral and managed futures. In one alt-centric model they worked some commodities in as well. 

In one model that was more rounded multi-asset they had 72% of the domestic equity exposure allocated to iShares S&P 500 (IVV), iShares Total Market (ITOT) and iShares Quality Factor (QUAL). IVV and ITOT are in my ownership universe. Here is a comparison of the three going back a good ways. 


The correlation is very tight between all three of course. For much of the left half of the chart you can't even see the blue line, that's how tight it was to the total market ETF. I have a hunch that the reason the quality ETF pulled ahead was not so much what it owned, the current top ten has six names in common with the S&P 500, but what the quality fund does not own. 

Blackrock might have the wherewithal to be right more often than not when choosing factors (not being snarky, they might be pretty good at that) so maybe there can be a performance benefit but I do not believe there is any diversification benefit to weighting among those three.


The IVV/ITOT/QUAL combo is proportioned pretty close to how Blackrock has them weighted in the model that I am talking about. Again, I am not posting any detail about their models. Would you call that a discernible difference? There's no wrong answer but for me it is identical and not worth the work of have three funds versus just having one for large cap US equities.

Modeling is absolutely valid. The way I build portfolios is not with a rigid, cookie cutter model, more like a lot of overlap with tweaks to account for client specifics. My practice is small enough that this is easy to manage. I don't know with a platform like Blackrock or the other huge model providers whether they make changes for client/customer circumstances. If they don't, then it is probably because they expect the advisor to do that. It would be reasonable for model providers to conclude that the chunk being given to them to manage is left over after cash management needs or any sort of customization like trying to manage tax consequences of a large position in company stock. In that light, all dollars allocated to the ABC model goes into the ABC model exactly as designed, same as every other customer. For one customer, maybe the ABC model is essentially all of their money and for another customer, maybe only 20% of their money went to the ABC model.

In evaluating models, if I wanted to outsource portfolio management, extra holdings that have essentially the same exposure is one of the first things I would look for. If you go down this road as either a customer or an advisor, you need to learn what to look at and what questions to ask. Actually maybe not even learn what to look for, you could just ask about every holding and its relationship to the others. 

A model that owns both the S&P 500 and the US total market, I would need a pretty good explanation of how that adds value. It is pretty easy to imagine being able to cobble together two or three large cap proxies that do offer some sort of truly differentiating result. From there you could replicate whatever they're showing you in Portfoliovisualizer or something else to see whether they are offering value and innovative portfolio construction, or not. 

I said that one thing I was curious about was how they might size alternatives. I am very consistent in saying small slices. Blackrock doesn't necessarily agree and I see plenty of content from others who don't agree. If I am in an extreme minority on this, am I wrong, am I overly concerned about the risk of an alternative strategy coincidentally going down at the same time as equities? Managed futures did great in 2022 but what if it too went down 20%? 


You can see above what the portfolios are. Managed futures did poorly in nominal terms for a long time, even though I would argue that it did what it should, but in terms of trying to mimic 60/40 while avoiding bonds in their riskiest moment in my career, the huge weight to managed futures did not hurt the results. 

I'd love some reader input on whether you think my stance is too cautious and if so, why?

The information, analysis and opinions expressed herein reflect our judgment and opinions as of the date of writing and are subject to change at any time without notice. They are not intended to constitute legal, tax, securities or investment advice or a recommended course of action in any given situation.

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