Asset Class Update: Is Diversification Still A Free Lunch?

According to Barry Ritholtz of Ritholtz Wealth Management, a frequent contributor to CNBC as well as Bloomberg, “the beauty of diversification is that it’s about as close as you can get to a free lunch in investing.” Since 2011, however, investors who diversified in stocks outside of the U.S. and who diversified across other asset types (e.g., commodities, currencies, gold, pipeline partnerships, etc.) have consistently underperformed the plain vanilla approach of owning the S&P 500 SPDR Trust (SPY) alongside a modest buffer of Vanguard Total Bond Market (BND).

Of course, the S&P 500 itself has struggled year-to-date (through 11/16). The price has essentially flat-lined over ten-and-a-half months at 0%. It follows that one might be led to believe that underwhelming performance in the large-cap benchmark might imply overwhelming performance elsewhere. After all, this is where diversification should shine.

So, then, has the “free lunch” of diversification finally make a comeback? Hardly. Consider the list of 16 asset types and accompanying exchange-traded vehicles in the table below.

An investor or money manager who dutifully maintained an allegiance to diversifying across asset classes (e.g., stocks, bonds, currencies, commodities, etc.) as well as within those classifications (e.g., small, large, foreign, domestic, short, long, investment grade, higher-yielding, etc.) is not being rewarded for the effort. In some corners, the risk-adjusted negative returns might be superior to the risks associated with a large-cap-only portfolio. After four years, however, faith in the free lunch of diversification may be dissipating.

It gets worse. As the end of 2015 approaches, tax-loss harvesters may decide that it is better to get rid of year-to-date losing propositions such as iShares Russell 2000 (IWM), Vanguard FTSE Emerging Market (VWO), iShares iBoxx High Yield (HYG), SPDR Gold Trust (GLD) and Vanguard REIT Index (VNQ). Meanwhile, the proceeds may flow back into the large-cap stock arena, where marginal gains still look better on paper than the losses from the less-than-desirable diversified results.