To Diversify or Not to Diversify, What are the Questions?

If we lived in a world with an infinite time horizon and no expected withdrawals from an investment portfolio, we could render the consideration of volatility risk and drawdown capture inconsequential. However, we live in the real world, where investment portfolios are expected to produce distributions. While the intent of a well-constructed portfolio is to maximize return per unit of risk, sometimes investors are paid to take risk and at others, portfolios are not compensated to take risk.  Unlike four years ago, today the slope of the risk/return tradeoff is very muted by historic standards. Yet, as stock markets have continued to set new record highs, many may consider repositioning their strategies strategically to take more risk.

One way that Balentine clients are able to increase their risk is by excluding the Manager Skill building block (an allocation to hedge funds), gearing only into Balentine’s tactical insights in the Safe and Market Risk building blocks (public markets). Under very strict circumstances, investors can consider this – what we refer to as our Global Tactical Asset Allocation (GTAA) strategies.  Such strategies rest on a two- not three-legged stool, so they come with much more risk. Investors should assess four criteria that measure both their ability and actual willingness before considering using a GTAA strategy.

The following four criteria provide the context and parameters for this decision:

  1. Time Horizon:  What is the investment horizon? Without volatility management through more complete diversification, a portfolio typically requires a sufficiently long investment horizon to produce returns consistent with expectations. The mechanics of negative compounding require longer periods of positive returns to overcome drawdowns. Furthermore, this does not even consider permanent impairment of capital from spending from a portfolio during declining markets. For example, consider that the range of expected annualized returns contracts through time and that the range of outcomes diminishes further as volatility levels decrease. The wider the dispersion of possible outcomes, the more time required to offset negative returns. We expect that a fully diversified portfolio will achieve positive annualized returns approximately 63% of the time required for a non-fully diversified portfolio to accomplish the same objective.  Additionally, with a GTAA portfolio, the time to recover from an equity market drawdown substantially lengthens.
  2. Spending Requirements:  Current liquidity policies preclude clients who spend from the portfolio from investing in an Aggressive strategy at Balentine. Before implementing a GTAA strategy for portfolios with spending requirements, investors should fully understand the rationale for the spending policy. Typically, maintaining 1- 3 years of spending in liquidity and safe assets should hedge against the need to raise capital from a temporarily depressed asset class to fund the distribution. Generally, Safe assets have a lower probability of incurring a significant draw down and becoming permanently impaired. However, it is possible for both Safe and Market Risk to decline simultaneously, in which case Manager Skill should source additional spending requirements. Portfolios with spending requirements in excess of the portfolio yield should carefully assess the potential for permanent impairment of capital after the liquidity reserve (today’s policy dictates 12 months in cash/short duration bonds) has been exhausted. Also consider how the spending policy is structured. If the spending policy is dynamic and can expand or contract as a percentage of the portfolio over time, there is greater flexibility to withstand drawdowns. Establishing the maximum threshold for spending compression will quickly verify if a GTAA strategy is appropriate.
  3. Portfolio Contributions (frequency and magnitude):  A portfolio with regular and sizable contributions is better able to handle the additional volatility associated with a GTAA strategy.   The frequency and size of the contributions are inter-dependent and subject to the size of the client portfolio. Generally, the more frequent the contributions, the more volatility the portfolio can withstand, subject to the constraint that the contributions are of significant size relative to the existing portfolio. Incremental portfolio additions provide another means to capitalize on volatility and provide rebalancing to target weights which both serve to manage risk.
  4. Behavioral:  If the ingredients are present to implement through a GTAA portfolio, one must finally consider behavioral biases. Investors must be able to adhere to a long-term disciplined approach during severe market corrections. Not having the fortitude to continue or increase contributions during down turns or wanting to scale back risk in the midst of a crisis could potentially impair capital and reduce the risk-adjusted performance. Therefore, it is equally important to gauge the actual willingness to take risk versus the ability and perceived willingness to take risk described in conditions 1-3 above.

The main reason investors may choose to consider investing in a GTAA strategy is the upside deviation. While greater volatility can potentially produce much larger losses, it can also potentially create much larger gains over shorter periods. Given enough time, the annualized returns of both fully diversified and GTAA strategies will gravitate toward the expected return (mean); therefore, it is the interim time between today and perpetuity that volatility and drawdown capture affect strategy decisions.

These conditions are not hard and fast rules to cover each individual investor’s situation. However, in addition to portfolio size and age, they do provide guidelines as to how it is essential to expand the assessment to include spending, contribution policy and behavioral aspects before allocating to a non-fully diversified GTAA strategy.

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