Thursday, June 29, 2017

Diversification without some pain is not diversification

“No one likes losing money, but if something in your portfolio isn’t giving you heartburn, you’re probably not diversified.” - John Lindner, PCA Consulting 

How many times have you recently heard, "My hedge funds are not generating enough performance relative to my equity portfolio. Why am I holding this stuff?" 

The answer is simple. It provides diversification. This diversification can be across markets, time-frames, factor sensitivities, and styles of return generation. Diversification by its very nature means that there will be performance differences and return gaps. A well-diversified portfolio will have assets that do not move together, so it should not be surprising that if an asset is added to generate diversification it will not match the core performance of equities and bonds. If performance across portfolio exposures si similar, diversification was not achieved. 

Nevertheless, if the correlation between two assets is negative, it does not mean that if the return of one asset is positive the other will be negative. Many often confuse deviations from mean returns, the core measure in covariance, and absolute performance differences. The correlation is the covariance of two assets scaled by their standard deviations. The covariance is the relationship between the deviations from the mean of each asset. Hence, you can have positive correlation and a wide gap in performance between two assets or you can have a negative correlation with little gap in assets. 

Still, if there is dispersion in returns, both good and bad across asset in the portfolio, then the diversification is doing its job. Learn to relax about differences in correlation. 

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