A few things from around the interwebs over the weekend.
First up is a paper from Research Affiliates titled Building Portfolios: Diversification Without The Heartburn. The paper targets a portfolio with a 10% volatility, a pretty low number and because of current valuations believes the way to get there is to have only 27.5% in equities but no domestic equity exposure, just foreign. Other exposures in the mix include 5% in bank loans, 6.7% in non-dollar denominated emerging market debt, 5.3% in commodities and 7.1% in what it calls “local and foreign cash.”
With a starting point being 60/40 equities/fixed income, the proposed (theoretical?) portfolio allocates 37% to fixed income so that’s not far from 40 but takes a lot from equities to put into diversifiers. Emerging market equity gets about 2/3rd of the overall equity allocation and using iShares funds as proxies, emerging market equity has a standard deviation of 15% compared to 10% for the S&P 500 so maybe the authors are viewing EM’s standard deviation as a form of leverage, more bang for the buck although to be clear the paper doesn’t say that. While I do not doubt the heavy lifting that went into devising the portfolio, circling back to a point I’ve made repeatedly including just a few days ago, when you put too much into diversifiers you end up with a portfolio of diversifiers hedged with a little bit of equity and a poor upcapture in terms of participating in bull markets.
ETF.com posted about the extent to which some of the most popular, mega cap tech stocks have dominant weightings in many broad based ETFs such that someone could build a portfolio with several funds that seemingly cover different ground all with large weightings in the same couple of mega cap tech stocks. Someone might think buying a value fund, momentum fund, quality fund, earnings fund and dividend fund would create diversification but not necessarily.
This harkens back to the tech wreck more with traditional mutual funds where when the S&P 500 had a 30% in tech, many funds had 50%. Similar story with financials in 2007. With ETFs this is easily overcome thanks to their transparency, but the work needs to be done. There’s software/websites that can do the work for you or you can just open up a spreadsheet and do it yourself. After seeing the unintended overweight effect in 2000, I am surprised it repeated in 2007 but that then tells me it will happen again, maybe tech now or something else later. But there is no reason it needs to occur in your portfolio…as an unintended overweight. Choosing to have 40% in something will either work or it won’t but knowing you’re doing it is far better.
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