First a quick note on Israel's missile strike on Iran. The initial reaction of markets over night was a swift, but not huge, decline in futures. My thought process was "uh-oh" at first and then I thought, "ok how much work will this be?" The potential work would be to write up a quick "don't panic" note to email to clients. I pretty much had it half written in my head in about ten minutes because the message from any scare or actual decline is always the same. I don't know what will happen but at some point the event will end and then the market will start working higher, we just don't know how long it will take.
The other bit of work would be if the market actually crashed, what would I do? It would mean increasing net long exposure which is the easy decision. The harder one is how. Just buy a broad market index ETF? Maybe or would just selling BTAL make sense or maybe both, buying an ETF and selling BTAL. Interestingly, I lost no sleep over it which I mean literally. The market opening flat on Friday and then drifting lower later in the day looks more like the recent malaise to me than having to do with Israel/Iran but we'll see more next week I suppose.
On to today's post. Morningstar had a very shortsighted article to recap its diversification landscape report. The basic summary is that they blended together a bunch of asset classes, of which only gold had negative correlation to US large cap, and that blend lagged in 2023. What is shortsighted about it is the time frame. You could repeat the exercise every year and compare against the thing that outperformed and of course diversification will lose.
Allocating to things like value or mid caps won't offer much diversification benefit. Yes, style and size allocations could absolutely improve performance but with correlations of 0.94 to large, market cap weighted, value and mid cap, and plenty of others won't zig when the stock market zags.
We talked about this the other day, it is easy to discount the value of diversification when the stock market is going up. Owning 50 different stocks will diversify issuer risk but not market risk which is the context of what the Morningstar article was about (market risk). The simple rule of thumb is if they all going up together, like with a 0.94 correlation, then they should all be expected to go down together.
The other day we looked at the Cambria Trinity ETF (TRTY) which targets 25% to equities, 25% to bonds (along the lines of the AGG I believe), 35% to trend and 15% alternatives. It is a variation on All-Weather and with that sort of approach there will be years where it looks much different than 60/40.
I circled the three years with the biggest differences. Also, 2023 it noteworthy. The Trinity Replication captures some of the effect of the market longer term, maybe enough, maybe not enough, you can look at the other post to get more numbers, but that is what real diversification looks like.
We work on theoretical portfolios here all the time that blend in strategies that really are negatively correlated or at least very little correlation.
The above are just a couple of examples inline with what we've explored before. They are not like TRTY but they are not like pain vanilla 60/40 either. Trend is managed futures and for alpha I used Blackstone (BX), the private equity companies tend to be far more volatile than the S&P 500 and tend to outperform in both directions. Both portfolios have higher standard deviations than the Trinity Replication but much higher returns.
Portfolio 2 was up in 2022, Portfolio 3 was down only down 7% that year versus a decline of almost 17% for 60/40.
They have better upcapture than Trinity Replication but offered real diversification when it was most needed in 2022. Trinity Replication though, offered more protection during the 2020 Pandemic Crash, In the very fast crash at the end of 2018, both portfolios above lagged 60/40.
One take away is that nothing can be best for all times. We say that repeatedly here. A strategy can be very effective most of the time even if it does not perform every time. Enduring a real crash defined as a fast decline that snaps mostly back very quickly is more about behavior IMO than portfolio construction. Enduring a bear market is about both, behavior and portfolio construction.
Accounting for every possible adverse market scenario is not realistic. The way we frame it in these posts and the way I manage client accounts is to try to avoid the full brunt of large declines. The mindset for this for how to do this is to blend strategies together in such a way that there is a reasonable probability for getting the outcome I want, most of the upside, less of the downside, realizing that even if an approach like this could work most of the time, it might not work every time.
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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