Is Diversification Dead?

The title of today's post is essentially the question asked in a Bloomberg Article (syndicated at Yahoo). The TLDR is that broad diversification has lagged behind simple market cap weighting for the last 15 years. I am guessing they chose that timeframe to coincide with the March 2009 bottom. 

We've talked just a couple of times about the market becoming increasingly concentrated which just in terms of math means that a diversified strategy will lag for as long as the big names do well. According to the article, the only "asset allocation" fund to outperform the S&P 500 over the last 15 years has been the PIMCO StocksPLUS Long Duration Fund (PSLDX) which ironically enough is a leveraged fund tracking 100% each to stocks and long term bonds. The concentration issue could continue to accelerate from here with Evercore saying they can see Nvidia (NVDA) growing to 15% of the S&P 500 from its current six-ish.

This sort of top heavy market is a negative for the market. The largest stocks need to continue to do a lot of heavy lift for the market to have its best chance of continuing higher. That does not mean stocks must go lower and of course it is possible for the index to lift without the big three, just that it makes it more difficult. There are always reasons for markets to go up and always risk factors, this is merely a risk factor. 

Despite outperforming for 15 years, PSLDX was down 43% in 2022 which speaks to what diversification is about. Outperformed long term but down a sickening 43% and still down about 25% from its late 2021 highwater mark. In thinking about diversification, what problem are you trying to solve? Or maybe a better way to put it is, what outcome are you trying to avoid while at the same time, what are you trying to achieve?

One headwind to how investors think about diversification is that it is easy and common to forget what large declines feel like after a few months or a couple of years of strong market performance like we're sitting on right now. This is the point in the cycle where the sentiment of "should I put it all in the S&P 500 and forget about it?" happens. The answer for most investors is no. The time to ask that question is after a large decline like Q3, 2022 and the answer for most investors would still be no. 

Going 100% S&P 500 can absolutely get the job done but every now and then the declines will be brutal which is why diversification exists. How many articles have you read about bonds being a good ballast for equity volatility? The love the word ballast. 

Diversification has multiple reasons to exist. First is to help cushion the blow of large declines. Bonds did that for 40 years as interest rates went from mid-teens to just north of zero. In 2022 they didn't work. This might be an example for Karl Popper; all the positives in the world can't prove a theory but it only takes one negative to disprove a theory. 2022 was the negative to disprove that bonds with duration effectively diversify against equity volatility. 

Another important reason for diversification is to avoid an adverse sequence of returns disrupting some sort of near term life event, typically we talk about retiring in this context. Long duration fixed income has always had equity beta, it just so happens that 2022 is when it worked against investors. I looked at the Vanguard Target Retirement 2025 (VTTVX) and the Vanguard Target Retirement 2030 (VTHRX). In 2022 they were down 15.55% and 16.27% respectively, just slightly ahead of Vanguard Balanced Index (VBAIX) which was down 16.87%. I've been bagging on target date funds since they first came out with 2022 being the latest example of why I think they stink. They can get the job done if that is all someone has access to in their 401k but they need to figure something out as they get close to retiring because they are not protected against sequence of return risk.

Back to the questions above, what are you trying to achieve, what outcomes do you want. The point of diversification is to (hopefully) be less volatile than the broad market to minimize the odds of succumbing to emotion and panic selling along with getting a long term rate of growth adequate enough to ensure you have have enough when you need it and stay at least a little ahead of price inflation. All the better if all that can be done without constantly worrying about the ups and downs of markets.

Quick pivot to close out, again invoking Karl Popper. For many years I talked about zero weighting to a sector as being a big bet even if unintentionally. I've been effectively zero weight energy in terms of big oil for quite a while now. Here's an interesting chart comparing the S&P 500 and the Pro-Shares S&P 500 ex-Energy (SPXE).

ETF.com has the energy sector currently at 3.1% of the S&P 500. Back before the financial crisis it was closer to 6% and 40 years ago it was 30% believe it or not. In the period available to study SPXE, there has been no difference in  returns, volatility or portfolio stats. 

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.